Trying to figure out what in the money options are? If so, you’ve found the right article because we’re going to take a minute to explain exactly what these types of options are. Options are a bit complex, but with some time and effort, every investor can learn about these great investment vehicles.
Option prices can be very complex, so all of the numbers used in this article will merely be used to illustrate things, not to reflect real-life prices. Exercising stock options can also be a bit complex, so we recommend you study up on that elsewhere.
Anyways, let’s get back to in the money options and what they mean. Such an option means the option itself is worth exercising. Remember, options give the option holder the right to buy or sell an option at a predetermined price.
How You Make (or Lose) Money in Call Option: An Illustration
Let’s say you buy a call option for Acme Motors that is currently selling for $20 dollars. You buy the call option with a strike price of $15 dollars (meaning you can buy Acme Motors for $15 dollars a share). This means you’d instantly make $5 dollars.
Of course, there’s no such thing as free money. You’ll have to buy the options, which cost money. The costs will certainly be bigger than any instant gains. For example, if you buy the above options with that strike price, you might pay $7.50 for the option, meaning that you’d lost $2.50 if you sold them while Acme stocks are selling for $20 dollars.
Option pricing, and your gains/losses can be difficult to calculate. The above numbers are only for illustrative purposes. We suggest you use a stock option calculator when looking to make real investments. Such calculators can be a big help.
Understanding Covered Call Strategy
Investors sometimes use the covered call strategy when they are holding a stock for a long term investment, but believe that in the short term the stock probably won’t gain much.
With a call option you are given the option to buy an asset at a certain price. However, if you own stocks you can write your own call options and sell them. So let’s say Acme Motors is selling for $20 dollars a share right now and you’re holding onto 100 shares. You’re very confident that Acme Motors will do well in the long run but believe that in the short run the stock will be relatively flat.
So you end up writing covered calls, or call options backed with your own stocks. You set the strike price at $22 dollars for Acme Motors, believing that prices will stay below $22 dollars and thus no one will end up exercising the option.
Let’s say you sell the options for $3 dollars a piece, meaning you rake in $300 dollars on your options. If the options expire before being exercised, you pocket all of that money. The same is true if prices for Acme motors stocks fall. You’ll likely lose some money if stock prices fall because of your losses from the stocks themselves. However, your losses will be mitigated by the gains from the stock options.
If stock prices rise above $26 dollars, the option will be exercised and your gains are capped at $26 dollars.
A Hedge from Risks, But a Cap for Potential Gains
This is obviously a pretty complex strategy, but it’s a great one for people looking to hedge risks, and who are investing in stocks that will probably trade flat in the near future. The biggest downside is that you cap your potential gains if prices should rise sharply.
Of course, every type of investment comes with benefits and risks, that’s the nature of investing.