Out-Of-The-Money Puts

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Strategies for Selling Deep Out of the Money Put Options?

Selling put options can bring a steady stream of income into your brokerage account. Put selling is a strategy suited to a rising stock market. Selling far out-of-the-money puts minimizes the risk that a sold put contract will turn into a big trading loss. The profitability of the strategy should be calculated and compared option trading options.

Selling Put Options

A put option gives the option holder the right to sell the specified stock or security for a predetermined price until a set expiration date. The price of the stock at which the option can be exercised is called the strike price. When you sell the put, you receive a premium from the buyer. You must buy the underlying stock at the strike price if the put holder elects to exercise the contract. You want the stock price to stay above the strike price until the option expires. If this happens, you keep the premium from selling the put with no further obligations.

Covered vs. Naked Puts

You can sell cash secured puts, with cash designated in your account to cover the put if it’s exercised. If a sold put has a strike price of $25, you would need to put up $2,500 for each contract sold. You may elect to sell far out-of-the-money puts to avoid the necessity to cash secure the contracts. Far OTM puts have a low likely hood of being exercised. For example, if the stock is at $50 per share and you sell put options with a strike price of $25, the stock would have to decline from $50 all the way below $25 for you to start to lose money on the trade. The trade-off of selling far OTM puts is that the premium received for each contract is less than for puts with higher strike prices.

Potential Returns

A trader selling out-of-the-money puts is said to be selling naked or uncovered put options. You will receive the premium for the contracts sold, less the commission paid the broker. For example, with Apple stock at $346 per share, you elect to sell Apple puts with a two month expiration and a $300 strike price. The price of the option is $3.05. You would receive $305 for each contract sold (since each contract represents 100 shares) less the commission of $5 to $10. Your broker would require you to put up a margin deposit of at least 10 percent of the strike price times 100 shares, or $3,000 per contract, plus the premium received. The investment return would be $305 divided by $3,305 or a 9.2 percent return in two months if Apple stock stays above $300 per share.

Brokerage Account Considerations

Naked put selling can only be done in a brokerage account with the appropriate level of option trading privileges. Selling uncovered puts requires level five option trading authorization, the highest level for most brokers. Option trading levels are assigned based on your experience, net worth, and account balance. Stock brokers can require a minimum account equity of $25,000 to $100,000 for level five option trading authorization.

In the Money and Out of the Money Options and Their Intrinsic Value

An option contract’s value fluctuates based on the price of the asset underlying it, such as a stock, exchange-traded fund, or futures contract. The option can be in the money (ITM), out of the money (OTM), or at the money (ATM). Each one of these situations affects the intrinsic value of the option.

The amount of time remaining before the option contract expires also plays a role in the value of the option, which in turn affects how high or low a price—the premium—the buyer is willing to pay for the option.

In the Money

If an option contract is ITM, it has intrinsic value. A call option—which gives the buyer the right but not the obligation to purchase an asset at a set price on or before a particular day—is in the money if the current price of the underlying asset is higher than that agreed-upon price, which is known as a strike price. The buyer could exercise their right under the option contract and buy the underlying asset for less than its current value. That means the call has intrinsic value.

Conversely, a put option—which gives the buyer the right to sell an asset at a set price on or before a particular day—is ITM if the price of the underlying security is lower than the strike price. The buyer could exercise their right under the option contract and sell the underlying asset for more than its current value. That means the put has intrinsic value.

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In summary, a call option is a bet that the underlying asset will rise in price sometime before or on a particular day—known as the expiration date—while a put option is a wager that the underlying asset’s price will fall during that time period.

If the strike price of a call option is $5 and the underlying stock is currently trading at $6, the option is ITM. The higher above $5 the price goes, the more ITM the option is and the greater it’s intrinsic value.

If the strike price of a put option is $5 and the underlying stock is currently trading at $4, the option is ITM. The lower below $5 the price goes, the more ITM the option is and the greater it’s intrinsic value.

The intrinsic value of an option that’s ITM is the greater of the strike price or the price of the underlying asset minus the other price. Therefore, the intrinsic value for both the call and put options with the strike price of $5 is $1.

Out of the Money

If an option contract is OTM, it doesn’t have intrinsic value. A call option is OTM if the current price of the underlying asset is lower than the strike price. The buyer of the call option would not exercise their right under the option contract to buy the underlying asset because they would be paying more than its current value.

Conversely, a put option is OTM if the current price of the underlying security is higher than the strike price. The buyer of the put option would not exercise their right under the option contract to sell the underlying asset because they would be receiving less than its current value.

If the strike price of a call option is $5 and the underlying stock is currently trading at $4, the option is OTM. The lower below $5 the price goes, the more OTM the option is.

If the strike price of a put option is $5 and the underlying stock is currently trading at $6, the option is OTM. The higher above $5, the more OTM the option is.

Because these OTM put and call options can not be exercised for a profit, their intrinsic value is zero.

At the Money

If an option contract’s strike price is the same as the price of the underlying asset, the option is ATM. If the strike price of a call or put option is $5 and the underlying stock is currently trading at $5, the option is ATM. Because ATM put and call options can not be exercised for a profit, their intrinsic value is also zero.

Time Value

The value of an option consists of both intrinsic value and time value. The greater the amount of time until an option expires, the more time value it has. That’s because there is a greater chance the option will, at some point, become ITM over the longer time frame before expiration and so have intrinsic value.

When deciding how much of a premium they’re willing to pay, a prospective option buyer must take into consideration whether the underlying asset has or is likely to have intrinsic value and the option’s time value. An option can be OTM and consequently have no intrinsic value but still have time value up until its expiration. If an ITM option has $10 of intrinsic value, the premium should be higher than $10 because of the time value inherent in the amount of time the underlying asset has to become even more ITM.

In the Money, At the Money, Out of the Money Options

Moneyness of an option

Moneyness is a strange sounding term, but it is sometimes used for describing the amount of intrinsic value an option has. All options belong to one of the three basic groups (and they can move between these groups as the market price of the underlying changes, as you will see below). The three groups are:

  • In the money options
  • At the money options
  • Out of the money options

Shortcuts are frequently used for these terms and they are also used here on Macroption. In the money is ITM, at the money is ATM, and out of the money is OTM.

In the money options

An option is in the money if its intrinsic value is greater than zero (probably the most important sentence of this article, read it once again).

This means that if you would exercise an in the money option and immediately buy or sell the underlying stock in the stock market to offset the exercise, you would get more cash for the selling than you give away for the buying (you would be net cash positive from these transactions).

ITM call options – lower strikes

For a call option being in the money means that the market price of the underlying stock (or underlying security in general) is higher than the strike price of the call option. If you exercise the call, you would be buying the underlying stock for the strike price and then you could immediately sell the stock in the stock market for the market price, which would be higher. The difference, which is equal to the call option’s intrinsic value, would be your net cash inflow from the transaction.

ITM put options – higher strikes

For a put option things are just inverse. A put option is in the money when its strike price is higher than the current market price of its underlying security. You can buy the stock for the (lower) market price in the stock market and exercise the put option, which means selling the stock for the (higher) strike price. The amount by which the market price of the stock is lower than the option’s strike price is the put option’s intrinsic value, or as people say the value by which the option is in the money. Yes, all in the money options are not equal. Some are more ITM than some other.

How this relates to option prices

From the descriptions above it is evident that owning and ITM option is a good thing and the more in the money the option is, the higher intrinsic value it has, and the more valuable it is (other things being equal). Therefore, holding all other parameters constant, the more in the money an option is, the higher its price.

For calls, the lower the strike price, the cheaper you can buy the underlying if you exercise the call option, the more intrinsic value it has, the more ITM it is, and the more expensive the option itself is.

For puts, the higher the strike price, the higher you can sell the underlying if you exercise the put option, the more intrinsic value it has, the more ITM it is, and the more expensive the option itself is.

Out of the money options

Out of the money options are, as the name suggests, the opposite of in the money options. They are options whose intrinsic value is zero (it can’t be negative). OTM call options have a strike price higher than the current market price of the underlying. OTM put options have a strike price lower than the current market price of the underlying. It is not a good idea to exercise an out of the money option, as you would simply get a better price if you trade the underlying in the stock market without using the option.

At the money options

At the money options are somewhere in between ITM and OTM options. They are the options whose strike price is roughly equal to the current market price of the underlying. They are exactly on the edge. At the money options are usually among the most traded (most liquid) options, as they are the most “exciting” – in a short moment they can get in the money or out of the money as the market price of the underlying fluctuates.

Summary – to keep it simple and short

In the money (ITM): positive intrinsic value, generally calls with low strikes and puts with high strikes.

At the money (ATM): zero intrinsic value, strike price equal to market price of the underlying.

Out of the money (OTM): zero intrinsic value (because intrinsic value can’t be negative), generally calls with high strikes and puts with low strikes.

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