Trading options offers incredible leverage, but with that comes a critical choice: Do you trade out-of-the-money (OTM) or in-the-money (ITM) options?
Both have their place, but understanding when and how to use each is key to crafting a strategy that fits your goals and risk tolerance.
Knowing the big differences between the two is crucial.
OTM options are cheaper but riskier. They require the underlying stock to move significantly before they become profitable.
For example, if Tesla (TSLA) is trading at $270, an OTM call option with a $300 strike price won’t gain intrinsic value unless TSLA climbs above $300 before expiration.
These options offer higher potential percentage gains for a cheaper buy-in price, but they come with a major caveat — if the move doesn’t happen quickly, time decay (Theta) can wipe out your premium fast.
ITM options are more expensive but come with a higher Delta, meaning their price moves more closely with the underlying stock. Using the same TSLA example, an ITM call option with a $250 strike price already has intrinsic value. While the percentage gain may be smaller compared to OTM options, the trade is less dependent on big, rapid moves.
When to Use OTM or ITM Options
OTM options are best suited for high-conviction trades where you expect a strong move within a short time frame. Let’s say MicroStrategy (MSTR) is showing breakout potential, and you anticipate a sharp upward move.
You could buy OTM options with a Delta of around 0.40 — which means your contract moves 40 cents for every $1 the underlying stock moves — providing a balance between cost and responsiveness to price changes. However, keep in mind that time decay can erode your premium quickly if the move takes too long.
ITM options work well for trades where you want lower risk and are less concerned about maximizing percentage gains. For example, in the Consumer Discretionary sector (XLY), if Home Depot (HD) has shown strong support and you expect a steady upward trend, ITM options provide safer exposure.
They’re less sensitive to time decay and more likely to retain value if the stock moves sideways for a while.
Personally, I never go for less than a Delta of 0.40 for OTM options. This ensures the option isn’t too far out of reach while still offering good leverage. For ITM options, I focus on strikes with a Delta closer to 0.60 or higher, prioritizing stability and lower risk.
Key Takeaways
- Use OTM options for speculative trades with strong momentum expectations.
- Rely on ITM options for steadier, lower-risk setups.
- Always consider Theta decay and time to expiration when choosing your strike price.
By balancing OTM and ITM options based on your trade objectives, you can harness the unique advantages of each while mitigating their downsides.
The right choice isn’t about one being better than the other — it’s about using the right tool for the job.
Kane Shieh
Kane Shieh Trading
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*This is for informational and educational purposes only. There is inherent risk in trading, so trade at your own risk.
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