The investment term “in-the-money” refers to an option contract that is worth exercising because it has value.
A call option is “in-the-money” when the market price of the underlying security is above the strike price. A put option is “in-the-money” when the market price of the underlying security is below the strike price.
It is important to understand that an “in-the-money” option allows the holder to exercise it profitably. If the option holder does not exercise his right, then the option will expire worthless. An option holder can use that right to make a profit, or at least minimize his loss. Let’s look at a few examples that explain this.
Honda Motor Company (NYSE: HMC) has a price per share of $30. An investor can buy a call option for HMC with a strike price of $33 that expires in one month. In that one month, imagine that the market price of HMC jumped to $35. This rise in price above $33 means that the option is “in-the-money.” The option holder can exercise his right on this option and buy 100 shares of HMC at the strike price of $33, then sell them at the market price of $35. The option holder makes $2 per share, or $200 total. However, the option holder paid a premium to the option writer for the call option that costs $1 per share. So, the option holder collects a profit of $1 per share, based on receiving $2 per share by exercising the option and subtracting the $1 per share he paid in premium for the option. Thus, the option holder profits from an “in-the-money” call.
Honda Motor Company (NYSE: HMC) has a price per share of $30. An investor buys one put option for $1 per share for HMC with a strike price of $28 that expires in one month. In that one month, the market price of HMC drops to $27. This means that the option is “in-the-money.” The option holder wants to exercise his right on this option and sell 100 shares of HMC at the strike price of $28. He buys the shares at the market price of $27, then sells them at the strike price of $28. The option holder keeps $1 per share from that trade but needs to subtract the $1 per share premium he paid the option writer. In this example, the option buyer breaks even. This isn’t necessarily bad, since it allows the option buyer to recoup his original premium payment. If the option holder does not exercise his right on the option, or if the option was never “in-the-money,” then the option would have no value. Thus, the option holder would have been unable to recoup his original premium payment and would lose $1 per share, or $100. By exercising his right on the “in-the-money” option, at least he did not lose any money.
The strike price, also known as the exercise price, is the fixed price at which the owner of an option either can buy or sell an underlying security.
The strike price is determined at the time the options contract is formed. That strike price is agreed upon between the buyer and seller of the options contract.
Understanding what the strike price is, how it affects the pricing of options and how it determines the ultimate profit from trading an option should be understood.
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