A call option, or call, is a derivative contract that gives its holder the right to buy a security at a fixed price on a certain date. If that price is lower than the cost of buying the security on the open market, the owner of the call option can pocket the difference as a profit. Although options trading can be profitable, it is also more complicated than trading common stocks. Below we look at some of the benefits of buying options in the money.
Key points to remember
- A call option is in-the-money (ITM) when the current market price of the underlying security is higher than the strike price of the call option.
- Being in the money gives a call option intrinsic value.
- Generally, the more an option is out of the money, the lower its market price will be.
- Once a call option is in-the-money, it is possible to exercise the option to buy a security at a price below the current market price.
- In practice, options are rarely exercised before they expire, as this destroys their remaining extrinsic value.
Definition of options contract
When is a call option in-the-money?
A call option is in the money (ITM) when the current market price of the underlying security is higher than the strike price of the call option. The call option is in-the-money because the call option buyer has the right to buy the stock below its current price. When an option gives the buyer the right to buy the underlying security below the current market price, then that right has intrinsic value. The intrinsic value of a call option is equal to the difference between the current market price of the underlying security and the strike price.
One option is in the money (ITM) if the strike price is better than the market price. This means that the owner will make a profit by exercising the option.
One option is out of the money (OTM) if the market price is better than the strike price. There is no benefit to exercising these options until they go in the money.
A call option gives the buyer or holder the right, but not the obligation, to buy the underlying security at a predetermined strike price on or before the expiration date. “In the Money” describes the money of an option. The monetary character explains the relationship between the strike price of a financial derivative and the price of the underlying security. A call option is said to be “out of the money” if the strike price is higher than the price of the underlying security.
Generally, the more ITM an option is, the more it will cost to purchase. Conversely, out-of-the-money options cost less and they are cheaper the further out of the money they are. However, there are other factors that affect the price of an option, such as volatility and the expiration time.
A simple example
For example, suppose a trader buys a call option on ABC with a exercise price of $35 with an expiration date of one month from today. If ABC shares are trading above $35, the call option is in the money. Suppose ABC’s stock is trading at $38 the day before the call option expires. Then the call option is in the money $3 ($38 – $35). The trader can exercise the call option and buy 100 shares of ABC for $35 and sell the shares for $38 in the open market. The trader will have a profit of $300 (100 x ($38 – $35)).
Benefits of in-the-money call options
Once a call option is in-the-money, it is possible to exercise the option to buy a security at a price lower than the current market price. This allows you to make money on the option regardless of current options market conditions, which can be crucial.
Parts of the options market may be Something on time. Calls on thinly traded stocks and calls that are far out of the money can be difficult to sell at the prices suggested by the Black Scholes Model. This is why it is so beneficial for a call to go in the money. In reality, to the money (ATM) Options are generally the most liquid and most frequently traded, in part because they capture the transformation of out-of-the-money options into in-the-money options.
In practice, options are rarely exercised before they expire, as this destroys their remaining extrinsic value. The main exception is very deep in currency options, where the extrinsic value is only a tiny fraction of the total value. Exercising call options becomes more convenient as expiration approaches and the decadence of time increases considerably.
Disadvantages of Currency Options
While in-the-money options are more likely to generate profits, out-of-the-money options are much cheaper to purchase. This makes OTM options an attractive game for speculators willing to bet that the underlying security is likely to see significant price gains. The more an option is out of the money, the cheaper it is to buy.
A game for professionals
Overall, the game of entering the money and exercising options is best left to the professionals. Someone eventually has to exercise all the options, but it usually doesn’t make sense to do so before the expiration date. This means frantic exchanges on triple witchcraft days when many options and futures contracts contracts expire.
Small investors should generally plan to sell their options well before they expire rather than exercise them.
Most individual investors lack the knowledge, self-discipline, and even the money to actually exercise call options. Among these, the lack of money is the most serious problem. Suppose an investor buys a call option that is 13% out of the money and expires in one year for 3% of the value of the underlying stock. If the stock increases by 22% next year, the value of the investment will have tripled (22 – 13 = 9, or three times the initial 3). Sounds good, but there is a potential hitch.
Suppose the investor places $3,000 out of $100,000 in the call option described above. If the rest was cash earning 0%, the 3% risked is now 9%, for a total gain of 6%. What the investor really has at this point is the right to buy shares worth $122,000 for $113,000. Unfortunately, the investor only has $97,000 in cash. This is not enough to exercise the call option, so a trip to market makers is necessary.
Why would you buy an out-of-the-money call option?
Out-of-the-money call options are a speculative game of investors who believe that the price of the underlying stock is likely to rise before expiration. Many investors buy out-of-the-money call options before the company earnings call or other major announcements, hoping for positive news that will push the price higher. A famous example happened in the year 2021 Short press GameStopwhen retail speculators correctly predicted the stock price would rise.
What does it mean if a call option is out of the money?
A call option is out of the money if the price of the underlying security is lower than the strike price of the option. There is no benefit to exercising an out-of-the-money option, as it is cheaper to buy the underlying security in the market. For this reason, an option is worthless if it is still out of the money when it expires.
Is it better to buy in-the-money call options?
Options cost more if they are in the money, but they are also safer. Out-of-the-money options require a larger price movement to become profitable, and they are more likely to expire worthless. This makes out-of-the-money options a riskier bet, even though they are cheaper. It is up to each investor to decide how much risk they are willing to take.
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