There is a lot of nuance to options investing, so much so that many advisors and investors largely steer clear because it’s easy to feel overwhelmed pretty quickly and out of your depth. Derivatives are worth consideration, however, because they open up all new avenues to expressing opinions and taking positions on how stocks might perform in the future, what markets may or may not do, or even provide a kind of insurance for underlying assets.
If a stock is the lever that an investor wants to pull, options are a lot like the dials and switches that fine-tune how much that lever gets pulled, when it gets pulled, or even protect it from being pulled too much by outside forces. They can give someone else the right to pull the lever if they want to — for a price, of course — in the form of a covered call or put stop gaps in place to prevent the lever from being pulled down too far in the form of protective puts.
I wrote up a piece in May that breaks down covered calls and protective puts in more detail and why advisors might want to use them, which you can find here. Today the topic is all about moneyness, whether a contract is at the money, in the money, or out of the money, and what that means for puts and calls.
Moneyness isn’t some distant relation of the Loch Ness monster, though trying to understand it sometimes can feel like plumbing those depths that Nessie inhabits: moneyness is how an option’s strike price relates to the price of the underlying asset. It’s a way to easily talk about if an option would make money if exercised immediately or not. Selling an option and breaking even is considered at the money; everything else beyond that is either in the money or out of the money, depending on what kind of option it is and the strategy.
In the Money Calls and Puts
Options currently “in the money” mean they can be exercised for a profit and therefore are generally more expensive than their “out of the money” peers. It doesn’t mean they are better than out of the money options; which one is better applicable is entirely dependent upon the strategy being employed.
Call options grant the holder of the contract the right to buy a stock at an agreed-upon strike price within the window of the contract, while a put option grants the holder the right to sell the stock at a predetermined strike price within the window of the contract. An in the money call means that the strike price is lower than the current price of the stock, whereas an in the money put means that the strike price is higher than the current price.
There is a lot more to the math that has to do with intrinsic value, time value, and extrinsic value, but that’s a deep dive for another day.
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Out of the Money Calls and Puts
As you might guess, out of the money means the position of the option is the opposite of ITM, meaning that it isn’t currently in a profitable position if it were to be exercised immediately, but this doesn’t mean that an investor is just throwing away money by investing in an OTM call or put.
Example of ITM and OTM:
- A call option is purchased with a strike price of $105. It’s ITM if the underlying asset has a price above $105 and OTM if the current price is below $105.
- A put option is purchased with a strike price of $100. It’s ITM if the underlying asset is anywhere below $100 and OTM if the current underlying price is above $100.
Out of the money traders use options for a wide range of reasons and strategies: part of their appeal can be that they are cheaper, which also translates to being more volatile than their ITM peers because small price movements can have bigger impacts on returns. They also can be a way to hedge or provide a type of insurance for investment. Buying an OTM protective put as a kind of insurance for the underlying asset owned during market volatility can protect against large losses at a reduced cost.
OTM Puts in Action
Garrett Paelolla, managing director and portfolio manager at Harvest Volatility Management, recently discussed using OTM puts for this very thing in a risk management scenario through a collar strategy. A collar strategy entails holding shares of underlying security while simultaneously buying protective put options and writing covered calls for the same security.
HVM has been honing how they use a collar strategy that generates income through covered calls and reduces volatility while providing a measure of downside protection through protective puts for almost a decade. HVM currently provides portfolio management for Nationwide’s ETF lineup.
“Both the short calls and puts are implemented monthly and at the same time. We sell a call to finance the purchase of the put,” Paelolla explained. “The puts range from approximately 5-10% out of the money when they are initially put on.”
The options used are all for a 30-day period and then are reset, and as an active manager, HVM can close out the call so that more of the underlying assets can participate in a market rally should one occur or if most of the premium has been captured and the rule has been triggered. The OTM put remains in place for the month and then is exercised if its conditions are met and reset for the next month.
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