Options are classified as either “in the money,” “at the money” or “out of the money.” Each of these phrases has a distinct meaning and each option strike price will fall into one of the three categories.
If you will keep in mind that options convey rights to the buyer — the differences between the three types will be easier to understand.
Let’s quickly review the rights for each option.
Puts
Buying a put gives you the right to sell the stock for the strike price anytime before expiration.
Calls
A call gives you the right to buy the stock for the strike price anytime before expiration.
At the money
There is typically only one strike price that is considered “at the money.” That strike price is the one closest to the current stock price. In the chain sheet below, the at-the-money strike price is $550. That is because the current price of the stock is $550.80 per share. There is no other strike price closer to current price of the stock.
Options Chain Sheet
In the money
The “in the money” strike prices are those with “intrinsic value.” Intrinsic value means that the right conveyed by the option is worth something.
For example, if you owned the 530 strike call above, you have the right to buy the stock for $530 a share. Because the current price of the stock is $550.80, the option has intrinsic value of $20.80 per share. Similarly the 540 put strike price has intrinsic value of $10.80 per share because that strike price is $10.80 below the current stock price.
Be sure to notice that the in-the-money option costs more than its intrinsic value. For example, the ask price for the 540 strike price is $29.60. The difference between the option’s price of $29.60 per share and its intrinsic value of $10.80 is $18.80. That excess amount is time value or “premium” and is something we will be discussing later in the course.
Out of the money
An option with a strike price that is out of the money is an option that has no intrinsic value.
For example, if a put with a strike price of 540 gives you the right to sell Google (GOOG) for $540 before expiration, that right has no value. That is because the stock is currently worth $550.80, therefore, you could sell the stock on the open market for more than you have right to sell it through the option.
However, these options still have some value because the stock could drop before expiration and it would then acquire intrinsic value. In this example, the value of the 540 put is $18 per share, which is all time value or premium.
There are three things to remember that will help you keep these terms straight.
- Puts with a strike price above the current stock price and calls with a strike price below the current stock price are “in the money.” The further the strike price is in the money, the more expensive that option will be because it has more intrinsic value.
- Puts with a strike price below the current stock price and calls with a strike price above the current stock price are “out of the money.” The further the strike price is out of the money the less valuable it becomes because it is less likely that the option will ever acquire intrinsic value.
- At-the-money options may be a little in or out of the money. They will, however, always be the strike price that is closest to the current stock price.
In the video below, I will work through each of these differences on a live chain sheet. I will also share a few tips for learning and remembering the differences between these three strike prices.
John Jagerson is a contributor to LearningMarkets.com. To learn more about him, read his bio here.
This article originally appeared on the Learning Markets Web site.
