ITM vs OTM Options: Short Story

Educational experience about the differences between In-The-Money and Out-Of-The-Money options for aspiring money makers by Marty & Premia.

This article is the second part of our Short Story series. Expect the unexpected – actually useful content brought to you by a real DeFi protocol in partnership with an industry professional. A short story!

Today, we’ll talk about In The Money (ITM) and Out Of The Money (OTM) options. If you’re on a journey towards becoming an options savant, you’re in the right place.

ITM this, ITM that… why should I care?

Understanding the differences between ITM and OTM options is crucial for anyone wanting to get serious. These concepts not only determine the cost and potential profitability of your options but also directly shape your risk profile and decision-making process.

In this story, we’ll reiterate the fundamentals of options (expanded upon inside, delve into the intricacies of ITM and OTM options, and provide practical insights on when and why to choose one over the other.

As per usual — take a seat in your Aeron, get caffeinated, pop a Zyn, whatever suits your groove. Time to put in the effort bros!

Please note that Premia does not provide investment advice, and nothing herein should be construed as such. Anyone considering trading or holding derivatives or crypto assets should be aware that the risk of loss can be very high, and it is upon each individual to seek advice from an appropriate professional advisor.

If you’re new here, we recommend completing the Options 101 and Greeks courses inside the Premia Academy before delving into this article.

What are Moneyness, Delta, and Intrinsic Value?

Learning about the difference between ITM and OTM options comes with some prerequisite information. Thus, as is becoming tradition, our Short Story series briefly summarizes these topics to make sure you can follow along without reading through dozens of separate articles.

I cannot stress this enough my bros — check out the academy for the basics, it’s free, it’s all there 24/7.

If you’re already familiar with the following concepts, feel free to skip forward to the meat and potatoes.

What is Moneyness?

Moneyness refers to the relationship between the current price of the underlying asset and the strike price of an option. It indicates whether exercising the option would be profitable. There are three main types of moneyness which we will cover in this article: ITM, OTM, and ATM.

What is Delta? 

Delta measures an option's sensitivity to the price movement of the underlying asset. It shows how much the option's price is expected to change for the $1 change in the asset's price. Delta ranges from 0 to 1 for call options and 0 to -1 for put options. 

What is Intrinsic Value?

Intrinsic value is the immediate profit if the option is exercised. For call options, it's the current price of the underlying asset minus the strike price. For put options, it's the strike price minus the current price of the underlying asset. 

ITM vs OTM Options: Intrinsic Value

In the money options have intrinsic value. For call options, this means the underlying asset's price is above the strike price. For put options, the underlying asset's price is below the strike price.

ITM options are more sensitive to price movements and typically cost more due to their intrinsic value. ITM call options have a delta closer to 1 (meaning their price moves nearly as much as the underlying asset) and ITM put options have a delta closer to -1 (their price moves in the opposite direction but by a similar magnitude). This translates to greater price sensitivity compared to OTM options.

Out of the money options don’t have intrinsic value. For call options, this means the underlying asset's price is below the strike price. For put options, the underlying asset's price is above the strike price.

OTM options are cheaper but require significant price movements to become profitable. OTM call options have a delta closer to 0 (their price movements are smaller than the underlying asset's price movements) and OTM put options also have a delta closer to 0. This means they are less sensitive to price changes compared to ITM options. 

Let’s look at an example: ETH Current Price is $3500

For Calls:

  • ATM: $3500 strike

  • OTM: Anything with a strike >3500 (3600, 4250, 6000, etc.)

  • ITM: Anything with a strike <3500 (1900, 2800, 3450, etc.)

For Puts:

  • ATM: $3500 strike

  • OTM: Anything with a strike <3500 (1900, 2800, 3450, etc.)

  • ITM: Anything with a strike >3500 (3600, 4250, 6000, etc.)

ITM vs OTM Options… Let’s Talk About It

While cheap OTM options might seem to offer the highest returns, ITM options actually provide higher returns. ITM options, with their intrinsic value and high delta (sensitivity to price changes), are more responsive to market movements. So, if you're confident about a specific price movement and normal market volatility, ITM options might be a better choice.

ITM options are more expensive than OTM options. If your market view is incorrect, you lose more with ITM options due to their higher cost. However, because you take on more risk, the potential reward is also higher. If your view is correct, ITM options, with their high delta and intrinsic value, provide greater returns.

The choice between ITM and OTM options hinges on your risk tolerance and market expectations. ITM options are like having a head start, they possess intrinsic value. Additionally, their higher delta translates to greater price sensitivity, meaning they amplify your gains (or losses) when the underlying asset moves. However, this benefit comes at a cost, ITM options generally have a higher upfront premium.

OTM options, on the other hand, are more affordable. But remember, affordability comes with a catch, there is no free lunch, they lack intrinsic value and require a more significant price movement in the desired direction to become profitable. This translates to lower potential returns, but also less risk in terms of initial investment.

So, when do you choose which?

  • Confident Conviction & Normal Market: If you have a strong conviction about the underlying asset's price movement and expect normal market volatility, ITM options might be a good fit. Their higher potential return and responsiveness to price changes can magnify your profits. However, be prepared for the steeper upfront cost. Especially on Further Dated Contracts.

  • Limited Capital & Big Move: If capital is limited but you're comfortable with a higher risk profile, OTM options offer a chance to participate in the market. Just remember, a significant price swing is needed to see profits. (This is not recommended to buy DEEP OTM calls and just ape)

Marty’s Thoughts: ITM vs OTM

The goal is to keep winning. This is why you need to learn what to long for when you long.

You see on Twitter huge option PNL swings from traders posting to the timeline. This is mostly gambling. Buying short dated outright directional bets only works so often, and you never know how many times they bought these types of contracts to hit one big winner. Options are the best financial tool to create any sort of payoff you can imagine, and you better use them wisely. 

Let’s review.

ITM options offer greater sensitivity to market movements due to their intrinsic value and higher delta, making them more responsive and potentially more profitable if the market moves in your favor. However, this comes with a higher initial cost and increased risk.

Conversely, OTM options are more affordable and involve lower upfront investment, but they require significant market movements to become profitable, translating to lower immediate risk but higher uncertainty.

Generally speaking, ITM options will be better in 90% of normal cases. Obviously, if there’s an absolutely massive and unusual move, OTM options can provide more return. However, most importantly — you want to make sure you win when you’re right, and lose as little as possible when you’re wrong.

Avoid the allure of gambling on short-dated options and memecoins without a clear strategy. Instead, leverage the versatility of options to create payoff structures that align with your goals and risk management plan.

Stay winning my bros.

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