Options contracts give the holder the right to buy or sell an underlying security at a predetermined strike price for a limited amount of time. If the underlying security is trading at a price that makes the exercise of the option profitable based on the strike price, the options contract is trading "in the money."
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.
If an option is in the money, traders 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 if a trader believes that eBay (Nasdaq: EBAY) will move sharply higher after it announces its quarterly earnings, the trader can buy 100 shares of EBAY for an investment of about $5,000 if the stock is trading at $50 a share.
An in-the-money option would be any call with a strike price less than $50. If the trader bought a call with a strike price of $45 with 60 days until expiration that was trading at $5.75, they would be able to invest only $575 and would still be likely to participate in 100% of EBAY's gains if the stock moves above $50.75.
If EBAY reaches $55, the trader who bought 100 shares of the stock would make $500, ignoring transaction costs, for a 10% return on their investment. A trader buying an in-the-money call for $5.75 would earn $4.25 per share as the option would have $10 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 who buys an option cannot lose any more than the initial cost of the option.
Sellers of options do face unlimited risk 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 but receive a little more than the current market price. In the EBAY example, the seller of the call would receive $50.75 for their shares if EBAY was trading at any price above $45 at expiration (exercise price of $45 + $5.75 premium). They would continue to own the stock if the close at expiration was under $45, but they would have received the income from the premium to offset any losses in the stock's price.
(This article originally appeared on ProfitableTrading.com.)