In-, at-, and out-of-the-money options
When you buy or sell an option, there are two different price points to be aware of for the underlying asset: Its fair value, aka the current market price, and the option’s strike price, aka the price at which you can buy or sell the underlying asset at a set date in the future.
An option’s strike price can either be below, near, or above the underlying asset’s current price.
Let’s say you want to buy a call option on Apple, whose shares are currently trading at $150. One call option may have a strike price of $140. Because your strike price is already below the fair value of the stock, we say that your option is in-the-money (ITM).
When an option is in the money, you could — hypothetically — exercise the option right away and sell the underlying shares at a profit! This clearly sounds too good to be true, and it is indeed. We’ll cover that later.
Another Apple call option may have a strike price at $160. You’re still bullish on Apple, but the stock hasn’t quite reached this level yet. In this case, the $160 option is out-of-the-money (OTM).
Finally, a call option may offer a strike price at or very close to the current $150 share price of Apple. This option is at-the-money (ATM). The two available strike prices closest to the fair value — one below and one above — are typically referred to as being at-the-money.
Note that all the above can simply be flipped on its head for put options: When the strike price is above the current value of the stock, the option is ITM. When the strike price is below the current value of the stock, the option is OTM.
Intrinsic vs extrinsic value
An option’s premium consists of two parts: Intrinsic value and extrinsic value.
An option’s intrinsic value is the amount by which it is “in the money”. Using our example above, if Apple is trading at $150 on the stock market and you buy an option with a strike price of $140, the option’s intrinsic value is $10.
This remains true throughout the lifetime of an option contract. A call option has intrinsic value as long as the strike price is below the market price. Similarly, a put option has intrinsic value as long as the strike price is above the market price.
Now, if the market price is below the strike price of a call option, it has no intrinsic value. The same goes for a put option if the market price is above its strike price.
Another way to think about an option’s intrinsic value is as the value of being able to buy or sell shares at the strike price rather than the market value. Your $140-strike Apple option has $10 of intrinsic value because the ability to purchase shares $10 below the market price should be worth at least $10.
Essentially, other people in the market are having to pay $150 for the stock while you get it at $140! Sweet deal!
Now, since the intrinsic value is defined by how much an option is in the money, it naturally means that OTM options have no intrinsic value at all. Rather, these options consist only of extrinsic value.
If you exercised an OTM call option immediately after purchase, you would buy the underlying asset at a higher price (your strike price) than what you could sell it at on the open market (its fair value), giving you an instant loss. Hence why all of an OTM option’s value is extrinsic.
An option’s extrinsic value is calculated by subtracting the intrinsic value from the option premium. Let’s say you paid $15 for the Apple option above. The extrinsic value of that option is $15 minus $10 = $5. So $10 intrinsic value and $5 extrinsic value.
Intrinsic vs extrinsic value at expiration
Once your option reaches expiration, only intrinsic value is worth something. The intrinsic value determines if you’re able to buy or sell the underlying asset at a favorable price relative to the market price.
In fact, intrinsic value can also be defined as what the option will be worth at expiration. Going back to our previous example, if Apple stock was still at $150 at expiration, your option would be worth $10. The initial $10 of intrinsic value would have persisted. However, since you paid $15 for the premium, you would still be at a loss.
How extrinsic value is determined
Several factors impact an option’s extrinsic value. The first obvious one, which we already covered above, is whether an option is ITM, ATM, or OTM — and, more importantly, by how much the option is ITM vs OTM. The further in-the-money an option is, the more intrinsic value it has, and thus less extrinsic value.
Furthermore, an option’s extrinsic value is impacted by the amount of time left till its expiration. In fact, extrinsic value is often referred to as “time value”. As the buyer of an option, you need something specific to play out. The more time you have on your side, the better — and the higher the premium and extrinsic value.
For as long as the underlying asset doesn’t move in your favor, the value of your option goes down. This concept is known as “time decay”. That’s why an OTM option with 1 month to expiration will have a higher extrinsic value than one with 1 week to expiration.
The final parameter we’ll cover here is something known as the “implied volatility” of the underlying asset. An asset’s implied volatility is actually determined by the prices of its options. When a stock is expected to be volatile, investors are willing to pay more for protection or speculate on the price movements, thus driving up its options prices.
The increased demand leads to higher option prices, which in turn implies higher volatility. Looking at two similarly-priced stocks, the one with more expensive options has higher implied volatility.
Further studies
We’ve covered what options are, how they work, and the most basic concepts you need to understand before getting into options trading. I strongly encourage you to really dig in and educate yourself as much as possible though.
Here I’ve listed some of the resources I’ve personally found to be the most helpful. Let me know what you think if you decide to check them out, or if I missed some that should be on the list 👇
Option Alpha University
Easily the most beautiful website with the best overview and easiest navigation. I love their short written explanations accompanied by videos.
projectoption
This site really helped me with some specific topics that I had a hard time wrapping my head around. The comprehensive articles are supported by awesome visuals that really help with the understanding of more complex concepts.
tastytrade
One of the most popular go-to places for all-things-trading. They have a huge catalog of educational content in various formats, best practices, glossaries, and more.
