In the Money (ITM)/Out of the Money (OTM)

Have you heard these terms and wondered what they mean?

Options are financial instruments designed to take advantage of price movements of stocks.  This is a very simplistic definition, because options actually involve many more financial maneuvers than just stocks.  Let's stick with stocks for now.  Options come in two types: Calls and Puts.  Both Calls and Puts can be bought or sold.  Although that represents four directions, in reality, options can be "played" in an infinite variety of moves, directions, expectations and techniques.  There are "Greeks" which refer to Green terminology to identify forces that affect the movement of options; there are expiration dates; and there are strike prices. 

Some people think of Call options as ways to buy a position, but that is erroneous, as Calls can also be sold.  So it is with Put options.  Even though there is a common misconception that Put options are used to sell a stock, Puts can also be bought, or, as is the mainstay of this blog, can be sold "naked" to generate income.

For both Calls and Puts, the strike price determines if the option is In the Money (ITM) or Out of the Money (OTM).  In a previous entry, I discussed BTU (Peabody Energy Corporation).  The closing price as of Thursday, April 21, 2011 was $66.02.  I sold a Naked Put expiring January 2013 at the $65.00 strike price and received a premium of $1120 immediately into my account.  That means that between now and January of 2013, if BTU remains above $65, I will get to keep the entire $1120 that I received.  Based on a Margin Requirement of $2340, my return on investment (ROI) is 47.86%.  Since BTU closed at $66.02, and the strike price is $65, my Naked Put is said to be $1.02 out of the money (OTM). 

In the case of Puts, if the market price of the stock is HIGHER than the strike price, it is said to be OTM.  Conversely, if the stock price is LOWER than the strike price, it is said to be ITM.

In the case of Calls, if the stock market price is HIGHER than the strike price, it is said to be ITM.  Conversely, if the stock price is LOWER than the strike price, it is said to be OTM.