Option Investor
Educational Article

In the Money (ITM) vs. Out of the Money (OTM)

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The basic question here, in case you havent figured it out, is: Is your option in or out of the money. Last week we learned the difference between options that are in-the-money (ITM) and out-of-the-money (OTM). Now that you have been enlightened, lets take a look at what good that information will do you.

An options price is made up of two elements: Intrinsic Value and Time Value. Intrinsic Value is simply by how much the option is in-the-money (ITM). Time Value (or extrinsic value) is everything else.

When an option is in-the-money it actually has some value. Its called intrinsic value. Where does this value come from? Lets look at an example.

Stock Price: $52.15
Strike Price: $50.00 Call
Price of Option: $3.75

If you own this option with a $50 strike price, you own the right to buy this stock at $50. The stock is already trading at $52.15 thats $2.15 above the strike price. That $2.15 is called in-the-money and also called intrinsic value. So, if you were to exercise your option and buy the stock, you would already be in a position to immediately sell that stock for $52.15. Thats $2.15 that would go right into your pocket to help defray the $3.75 cost of that option. Thats a good thing.

Now, look at the price of the option: $3.75. We already know that the option has $2.15 of intrinsic value. How much time value is in the price of the option? I know you cant stand the suspense, so Ill tell you. There is $1.60 of time value built into that option -- $2.15 (intrinsic) plus $1.60 (time value) = $3.75.

The time value has a lot of stuff in it. It depends on the amount of implied volatility is in that option, the amount of time remaining until expiration and where the underlying asset is trading in relation to the strike price.

Lets have some fun and apply what weve learned to GOOG. That way we get to play with big numbers. Get your calculators. You may not have enough fingers and toes for these. Above is the option chain for GOOG in May with a little over two weeks left to expiration. Ill get you started and then well see how well you grasp the concept.

Stock price: $394.75
Strike Price: $400.00 Put
Price of Option: $15.60
There is $10.35 of time value and $5.25 of intrinsic value.

Now Its Your Turn
Stock Price: $394.75
Strike Price: $390.00 Call
Price of Option: ___________
There is ___________ of time value and ____________ of intrinsic value.

Stock Price: $394.75
Strike Price: $390.00 Put
Price of Option: ___________
There is ___________ of time value and ____________ of intrinsic value.

Stock Price: $394.75
Strike Price: $400.00 Call
Price of Option: ___________
There is ___________ of time value and ____________ of intrinsic value.

Stock Price: $394.75
Strike Price: $410.00 Put
Price of Option: ___________
There is ___________ of time value and ____________ of intrinsic value.

Stock Price: $394.75
Strike Price: $390.00 Call
Price of Option: ___________
There is ___________ of time value and ____________ of intrinsic value.

Well, that should keep you busy for a little while. I hope you are actually taking the opportunity to practice these concepts. Theyre important. Ill post the answers in next weeks column. Good luck. You can do it. It will become easier and easier the more you practice.

Now that weve addressed intrinsic value and time value, you know about all the good stuff that makes up the price of an option. Next week well explore the concept of volatility and how it may affect the price of an option.

Missed Any Columns?
Hey, this is good stuff especially if youre serious about learning options. The Pulitzer people wont likely be knocking at my door any time soon, but Ive taught a lot of people how to conservatively and consistently make money and theyre still making money to this day. I hope youll become one of them. See the links at the end of this column and have a ball.

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This Is Good Stuff
Just a reminder that, if youre new to options, these basic articles are valuable. Print these articles out so you can reference them at your leisure. This is your bible for the options basics. Its information you need to know before you risk your hard earned dead presidents and it may very well become a collectors item. What better reasons can there be?

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Mike Parnos - A Little Knowledge Goes A Long Way
The outspoken Mike Parnos has been writing Option Investors very successful Couch Potato Trader column for over four years. Hes been trading and teaching options for over 15 years and knows what you NEED to know to trade options profitably.

Too many traders trade the more advanced option strategies without having a good understanding of options, how they work, and how they are meant to be used. The results? Say goodbye to your money. That is why there such a stigma attached to options. And thats a recipe for disaster. If you have more money than you know what to do with, losing $5,000 or $10,000 is no big deal.

However, if youve worked hard for your money, and you appreciate the value of a dollar, you should make every effort to learn everything you can about options before you put your money at risk.

Mike tells you like it IS, not how you hope it will be. As you read through the columns, feel free to send him your questions at support@optioninvestor.com.

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