Should you buy in- or out of the money options?

Believe it or not, this is probably the most emailed question I receive in my inbox about option trading. When you look up options for most underlying securities you're usually presented with a long list of, you guessed it, options. But is it better to buy an option that is in-the-money or out-of-the-money. Out-of-the-money options are definitely cheaper, but does that automatically mean that it's a good idea? It really all depends on your trading strategy and how quickly you expect the underlying asset to increase in value - so keep in mind the time frame. An out-of-money option is cheaper for a reason; there's a greater chance that the option will become worthless upon expiration. But it also yields higher returns when the underlying security does trade in your favor, the option may jump from $0.10 to $0.20 in a day, that a 100% increase! You basically can insinuate that if someone who is choosing an out-of-the-money option over an in-the-money-option contract, he or she has a higher expectation that the price of the underlying asset will rise/fall in their favor drastically. For those who are more cautious, want to reduce risk and don't expect a whole lot of volatility, I recommend to use in-the-money options, the returns aren't that high and it's more expensive to buy, but there's less risk involved (remember, your in-the-money option already has intrinsic value from the moment you buy it. In order to fully understand the basics of ITM, OTM or ATM options it's best to look at a chart that gives a visual presentation how ultimately an option trades, like the chart below.

Visualization of an Out-of-the-money Call Option; courtesy of FuturesOptionsETC.com

When the stock price was $50 when the call option was purchased (strike price of $52.50), you won't break even when the stock price moves to $53.10. Anything beyond $53.10 is profit.

There is a way to calculate your trading strategy outcome before you make the trade. You can use a so called options calculator. For instance, this is my result when I use the following values:

the September 27th $18.00 call for the VXX. Price per option = $0.53, 1 contract = $53 (100 x 0.53). With the table below I'm able to see the following:

Estimated returns:

• VXX at $17.04 on 31st Aug 2013
• Initial outlay: $53 (net debit) see details
• Maximum risk: $53 at a price of $17.15 on day 27th Sep 2013
• Maximum return: infinite on upside
• Breakevens at expiry: $18.53

Click image for a larger version.

You can use your own values and see what happens until the option expires at optionsprofitcalculator.com.

-Happy trading!