The options world is full of terms that might sound a little foreign to novice traders. But once you get up to speed with the terminology, it’s relatively simple to begin trading.

One term that’s critical to know relates to the “moneyness” of options. You may hear of a particular trade referred to as “in the money,” “out of the money,” or even “at the money”.

When it comes to options, knowing whether your contract is “in the money” or not can make or break your trade. So today we’ll break down just exactly what this means and how traders use it.

As you may already know, options contracts give the holder the right to buy or sell an underlying security. This takes place in the form of a contract, meaning they agree to do so at a predetermined strike price for a limited amount of time. The options contract is trading “in the money” if the underlying security is trading at a price that makes the exercise of the option profitable based on the strike price.

Call options will be in the in the money when the market price of the underlying security is above the strike price. Put options are in the money when the price of the underlying security is less than the strike price.

The following table shows the “moneyness” of a fictional “XYZ” stock trading at different prices in relation to its call and put options at the $75 strike price.

How Traders Use It

When an option is in the money, it has intrinsic value. This is where the power of leverage really comes into play for traders. They will usually be able to participate in market moves with a smaller investment than they would if they simply bought or sold the underlying security.

For example, let’s say a trader believes that eBay (Nasdaq: EBAY) will move sharply higher after it announces its quarterly earnings. The stock is trading for $60 per share. The trader can buy 100 shares of EBAY for an investment of about $6,000.

An in-the-money option would be any call with a strike price less than $60. So let’s say the trader bought a call with a strike price of $55 with 60 days until expiration. It was trading at $5.75 at the time of purchase, so they would be able to invest only $575. In this scenario, the trader should still be able to participate in 100% of EBAY’s gains if the stock moves above $60.75. ($55 + $5.75)

If EBAY reaches $66, the trader who bought 100 shares of the stock would make $600. That’s a 10% return on their investment. A trader buying an in-the-money call for $5.75 would earn $4.25 per share (or $425). The option would have $11 of intrinsic value, again ignoring transaction costs, and realize a return of 74% on their much smaller investment.

Why It Matters To Traders

In-the-money options allow a trader to profit from a market move with a relatively small investment. This strategy also limits risk, since the trader cannot lose any more than the initial cost of the option.

Options sellers do face unlimited risk (theoretically). And their maximum gains will usually be limited to the amount they receive in premium. A seller may be motivated to sell an in-the-money call option when they believe a decline is likely and they want to capture the premium. Another reason to sell in-the-money options could include a desire to sell a stock the trader owns already, but with the goal of receiving a little more than the current market price.

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