Is It Better to Buy ITM or OTM Options?

Financial options are versatile contracts offering the right, but not the obligation, to buy or sell an underlying asset at a predetermined price. Each option contract specifies a “strike price,” the price at which the transaction can occur, and an “expiration date,” marking the last day the option can be exercised. The underlying asset can be a stock, commodity, or index, and its current market price relative to the option’s strike price determines if the option is “in-the-money” (ITM) or “out-of-the-money” (OTM). This relationship is a fundamental aspect of options trading, influencing both their value and their potential use.

Understanding In-the-Money Options

An in-the-money (ITM) option possesses intrinsic value, representing immediate profit potential. For a call option, ITM means the underlying asset’s current market price is higher than the strike price; for a put option, it means the underlying price is lower. Intrinsic value is the direct difference between the underlying price and the strike price.

ITM options generally exhibit a higher delta, a measure indicating how much an option’s price is expected to change for every $1 movement in the underlying asset. A higher delta signifies that the ITM option’s price will move more closely in line with the underlying asset’s price fluctuations. For instance, a call option with a delta of 0.80 would typically see its price increase by $0.80 for every $1 increase in the underlying asset’s price.

ITM options are less sensitive to time decay (theta), the erosion of an option’s value as it approaches its expiration date. The intrinsic value component of ITM options provides a cushion against this erosion. Their rate of decay is generally slower compared to out-of-the-money options because their value is less dependent on the remaining time for the underlying asset to move favorably.

The capital outlay for purchasing ITM options is usually higher than for OTM options due to their intrinsic value. This higher cost reflects the immediate profitability built into the contract. The breakeven point for an ITM call option is the strike price plus the premium paid. For an ITM put option, it is the strike price minus the premium paid. These breakeven points are generally closer to the underlying asset’s current price, requiring less significant movement for the option to become profitable.

Understanding Out-of-the-Money Options

An out-of-the-money (OTM) option lacks intrinsic value, meaning it would not be profitable if exercised immediately. For a call option, OTM means the underlying asset’s current market price is below the strike price; for a put option, it means the underlying price is above. The entire price of an OTM option is composed of extrinsic value, which includes time value and implied volatility.

OTM options typically have a lower delta, indicating that their price moves less in response to changes in the underlying asset’s price. For example, an OTM call option might have a delta of 0.20, meaning its price would increase by only $0.20 for every $1 increase in the underlying asset’s price. This lower delta reflects the reduced probability of the option finishing in the money.

These options are more sensitive to time decay (theta) than ITM options. As an OTM option approaches its expiration date, its extrinsic value erodes at an accelerating rate, particularly in the final weeks, because there is less time for the underlying asset’s price to move past the strike price. If an OTM option remains out of the money at expiration, it expires worthless, and the entire premium paid by the buyer is lost.

The capital outlay required to purchase OTM options is lower compared to ITM options because they possess no intrinsic value. This lower cost can appeal to traders with limited capital or those seeking higher leverage. The breakeven point for an OTM option requires a more substantial move in the underlying asset’s price. For an OTM call, the underlying price must rise above the strike price plus the premium paid. For an OTM put, it must fall below the strike price minus the premium paid.

Comparing Option Characteristics

The fundamental difference between in-the-money (ITM) and out-of-the-money (OTM) options lies in their value composition. ITM options consist of both intrinsic value and extrinsic value, representing time and volatility. In contrast, OTM options possess no intrinsic value; their price is solely derived from extrinsic value, reflecting the potential for the underlying asset to move favorably before expiration.

Delta, which measures an option’s price sensitivity to the underlying asset, differs significantly between the two. ITM options have a higher delta, often approaching 1 for calls and -1 for puts, indicating that their price movements closely mirror those of the underlying asset. Conversely, OTM options have a lower delta, closer to 0, meaning they are less responsive to small price changes in the underlying asset and require a larger move to become profitable.

Time decay, or theta, impacts ITM and OTM options differently. While both types lose value as expiration nears, OTM options are more susceptible to this decay. Their value erodes at an accelerating rate, especially in the last 30 to 45 days before expiration, as the probability of them gaining intrinsic value diminishes. ITM options, with their intrinsic value, experience a slower rate of time decay.

The initial capital outlay for ITM options is higher because of their intrinsic value, making them more expensive to purchase. OTM options are cheaper, requiring a smaller upfront investment. This cost difference directly influences the breakeven point. ITM options have breakeven points closer to the underlying’s current price, meaning less movement is needed to cover the premium. OTM options, due to their lower cost but requirement for substantial underlying movement, have breakeven points further away from the current price.

OTM options offer higher leverage potential because a small percentage increase in the underlying asset’s price can lead to a much larger percentage gain in the option’s value due to its lower initial cost. This leverage also amplifies potential losses, as the entire premium can be lost if the option expires worthless. ITM options have a higher probability of expiring in-the-money due to their intrinsic value. OTM options have a lower probability of reaching the strike price and thus a higher risk of expiring worthless.

Aligning Option Choice with Market Outlook

Choosing between in-the-money (ITM) and out-of-the-money (OTM) options depends on an individual’s market outlook and trading objectives. When an investor has a strong directional conviction for a significant price movement in the underlying asset, OTM options might align with their strategy. Their lower cost and higher leverage potential mean that a substantial move in the anticipated direction could yield significant percentage returns on the capital invested. However, this approach carries a higher sensitivity to time decay, making precise timing and substantial price movement necessary for profitability.

Conversely, if an investor holds a moderate directional conviction or prioritizes a higher probability of success, ITM options may be a more suitable choice. While they require a greater capital outlay and offer less percentage leverage, their intrinsic value provides a buffer against time decay and increases the likelihood of the option expiring profitably. This approach is generally considered more conservative, aiming for consistent gains rather than maximizing speculative returns.

Implied volatility also plays a role in the pricing of both ITM and OTM options, though its impact can be more pronounced on OTM options. Higher implied volatility generally increases the price of all options, but it especially inflates the extrinsic value of OTM options, as it suggests a greater chance of the underlying reaching the strike price. Investors should consider whether current implied volatility levels are sustainable or likely to contract, as a drop in volatility can negatively affect option prices, particularly for OTM contracts.

The time horizon for a trade is another important consideration. Options with shorter durations are more susceptible to the accelerating effects of time decay, making ITM options, with their lower time decay sensitivity, potentially more appealing for short-term strategies. For longer time horizons, OTM options may have more opportunity for the underlying asset to make a significant move, but they still face continuous time erosion. The amount of capital an individual is willing to risk also influences this decision, as OTM options allow for exposure to the underlying with a smaller initial investment, while ITM options demand a larger commitment.