ITM vs OTM options: a guide for crypto option traders

Unlike trading spot or futures contracts, crypto options trading offers unique opportunities to simultaneously lock in gains based on changes in volatility and manage overall risk exposure. It's ultimately this versatility that draws crypto option traders to the tactic. To remain a successful trader over time, a critical options trading concept to master is the idea of In-The-Money (ITM) and Out-Of-The-Money (OTM) options. With ITM and OTM options representing varying levels of risk and reward, it might seem daunting to dive into. In this guide, we’ll break down the essentials of ITM and OTM options, comparing their pros, cons, and the crypto option strategies that traders use to gain an edge in the crypto markets.

TL;DR

• In-The-Money (ITM) options have intrinsic value, providing lower-risk opportunities, while Out-Of-The-Money (OTM) options are more speculative, with the potential for higher returns if market conditions shift in their favor.

• ITM options offer a higher chance of gains, lower risk, and are great for hedging positions due to their intrinsic value. Comparatively, OTM options provide leverage for speculative gains with limited losses. They’re ideal for bullish or bearish plays and strategies that benefit from increased volatility, like straddles and strangles.

• At-The-Money (ATM) options sit near the asset’s current price and balance risk and reward, making them suitable for traders seeking moderate cost and payoff potential.

• ITM options suit stable, lower-risk strategies, OTM options suit high-reward and high-risk plays, and ATM options offer a more balanced approach. Each type supports various trading styles, risk tolerance, and market outlooks.

What are crypto options?

Crypto options give traders the choice to buy or sell the underlying crypto asset at a specific price by a certain expiration date. Like their TradFi counterparts, crypto options are derivatives that are classified into two categories.

• Call options which provide the right to purchase a crypto asset at a set strike price within a specified timeframe.

• Put options which offer the right to sell a crypto asset at a strike price within a designated period.

Understanding the difference between ITM and OTM options helps traders choose positions that align with their market outlook and risk tolerance.

What does ITM mean when it comes to crypto options?

When an option is ITM, it has both intrinsic and extrinsic value. This means the strike price is favorable compared to the asset's current market price.In the case of ITM call options, the option’s strike price is below the current market price. If Bitcoin is trading at $70,000 and a call option’s strike price is $60,000, it’s considered ITM since exercising it allows the call holder to buy Bitcoin below the current market price. This gives us an intrinsic value of $10,000 and represents the amount of gains realized if the call option is exercised.

As for ITM put options, the option’s strike price is above the current market price. For instance, if Bitcoin is trading at $70,000 and a put option’s strike price is $75,000, it’s ITM since it allows selling Bitcoin above the existing market price. This results in an intrinsic value of $5,000 that'll turn into realized gains if the put is exercised.

Benefits of trading ITM options

As the preferred type of option for more risk-averse crypto option traders, there are many benefits to trading ITM options, such as the following.

• Lower risk: Since ITM options have intrinsic value, they're essentially low-risk forms of leverage since their value is directly tied to the underlying asset's price movement. If the crypto asset's price moves in your favor, you can earn gains from both the intrinsic value and any increase in extrinsic value. However, if the asset's price moves against you, your potential loss is limited to the premium you paid for the option.

• Higher probability of making gains: As they already have a positive intrinsic value, ITM options have a higher probability of not ending up expiring worthless compared to OTM options.

• Useful for hedging: ITM options can be used to hedge existing positions or protect against potential losses in a portfolio. This can range from being used in protective put or call strategies to more advanced multi-leg option strategies like collars.

• Early exercise potential: Given how ITM options usually have strike prices that are favorable to the current market price of the asset, crypto option traders have the choice and flexibility to exercise the ITM option if conditions favor it.

What does OTM mean when it comes to crypto options?

An OTM option lacks intrinsic value, meaning the strike price isn’t currently favorable compared to the asset’s market price. In the context of call and put options, it implies the following.

The strike price of OTM call options is above the current market price. If Bitcoin is trading at $65,000, an OTM call option might have a strike price of $70,000. These OTM calls have no immediate potential for gains if exercised as their value lies in their extrinsic time value, which reflects the potential for the asset's price to rise above the strike price before expiration.

As for OTM put options, their strike price is below the current market price. If Bitcoin is trading at $65,000, a put option with a strike price of $60,000 would be OTM. As mentioned, OTM puts have no immediate potential for gains if exercised as their value lies in their extrinsic time value, which reflects the potential for the asset's price to fall below the strike price before expiration.

Benefits of trading OTM options

While ITM options are popular for their lower risk profile, OTM options also offer certain advantages, especially for those with a higher risk tolerance.

• Leverage: OTM options offer significant leverage, meaning you can potentially make bigger gains despite using less trading capital if the underlying asset moves in your favor.

• Limited losses: If the underlying asset price doesn't move in your favor, your losses are limited to the premium you paid for the option. This amount can be significantly less than the premiums involved with ITM options.

• Handy for bullish or bearish speculation: Rather than commit an excess of funds, OTM options can be used to speculate on the direction of the underlying asset's price without risking the full value of the asset itself.

• Volatility plays: If you believe that the underlying asset's price will become more volatile, OTM options can be used to make gains from increased option premiums. In essence, this idea is the entire foundation behind crypto option strategies like straddles and strangles.

Now that you're familiar with the ins and outs of ITM and OTM options, let's now look at how crypto option traders are applying them to crypto option strategies.

Crypto option strategies: ITM vs OTM

Crypto option traders use both ITM and OTM options in various strategies to capitalize on different market conditions and risk preferences. Here are some common examples for reference.

ITM-focused crypto option strategies

• Protective put: Buying an ITM put option against a long position in the underlying asset works like a short-term hedge and can provide downside protection against a near-term catalyst. If the asset's price falls below the strike price, the put option can be exercised to offset losses.

• Covered call: Periodically selling a deep ITM call option against a long position in the underlying asset limits your potential upside gains but provides you with extra liquidity, which you can use to do some extra trading. However, if the asset's price rises above the strike price, the call option will be exercised, forcing the sale of the underlying asset.

• Calendar spread: Calendar spreads involve buying an ITM option with a longer expiration and selling an ITM option with a shorter expiration. This strategy benefits from the time decay of the shorter-term option, thereby allowing crypto option traders with a sentiment that's neutral or slightly bearish on the underlying asset to potentially lock in gains from the time value premium.

OTM-focused strategies

• Strangle: Buying both an OTM call and an OTM put option with different strike prices but the same expiration date is known as a strangle. This multi-leg options strategy is ideal for traders expecting a large price movement in the underlying asset but are unsure of the overall direction the asset is headed towards. If the asset's price moves significantly either up or down, one of the options will gain value while the other may expire worthless. Overall, the strangle strategy provides flexibility and the potential for large gains if the asset’s volatility increases sharply.

• Bull call spread: In a bull call spread, the trader buys an OTM call option and sells another call option with a higher strike price but the same expiration. This strategy benefits from an upward price movement and can be used to limit costs by offsetting the premium of the purchased call option with the premium received from the sold call. The bull call spread allows traders to participate in upward momentum with lower initial capital but has a capped potential for gains thanks to the short call’s strike price.

• Bear put spread: For traders with a bearish outlook, the bear put spread involves buying an OTM put option while simultaneously selling a put option with a lower strike price. This setup benefits from a downward movement in the asset’s price and helps reduce the premium cost by collecting a premium on the short put option. Similar to the bull call spread, this strategy limits both upside gains and downside risk, making it appealing for moderately bearish traders looking to control costs.

• Iron condor: The iron condor is a more advanced neutral strategy that comes in two parts. The first is where the trader sells an OTM call and an OTM put option with strike prices close to the last traded price of the underlying asset. Then, the options trader buys another call and put option at further OTM strike prices. Overall, this strategy becomes lucrative when the crypto asset's price remains within a specific range as the options ideally decay in value and expire worthless.

Choosing the right crypto options strategy

The best strategy for crypto options traders ultimately depends on your risk tolerance, time horizon, and outlook on the underlying asset. ITM options generally offer lower risk but also lower potential gains, while OTM options offer higher potential returns but also higher risk. It's therefore important to carefully consider the pros and cons of each strategy and to develop a sound trading plan before entering any option trades.

What are At-The-Money (ATM) options?

While most of the conversation typically revolves around the comparison between ITM and OTM options, At-The-Money (ATM) options are also a valid alternative if you're looking for a more neutral options position or if you're unsure about the direction of the underlying asset's price.

ATM options have a strike price close to the asset’s current market price. For instance, if Bitcoin is trading at $65,000, an ATM call or put option would have a strike price near that same value. ATM options contain both intrinsic and extrinsic value, making them a point of balance between ITM’s safety and OTM’s speculative edge.

ITM vs OTM vs ATM: comparing ITM, OTM, and ATM options

When choosing between ITM, OTM, and ATM options, it's important to consider your trading objectives, risk tolerance, and market outlook. Here’s a quick comparison to help identify which type of option might suit various strategies and scenarios.

Premiums involved

ITM options have the highest premiums due to their intrinsic value, making them more costly upfront but also more likely to retain value if the market stays relatively stable. ATM options fall in the middle, with moderate premiums because they're close to the current price. As the most speculative choice of the three option types, OTM options are typically the least expensive as they contain no intrinsic value.

Probability of expiring ITM

Expiration dates are a key concern as they can drastically impact option premium costs. ITM options have the highest probability of expiring in the money, which offers more predictable results and potentially lower risk. ATM options have a roughly 50% chance of expiring ITM, appealing to crypto option traders looking for a balance between cost and probability. OTM options have the lowest probability of expiring ITM, making them higher-risk but potentially high-reward if the market moves significantly in the expected direction.

Potential gains and losses

ITM options generally offer lower risk due to their intrinsic value, but gains are typically capped if the price moves beyond the strike. ATM options offer moderate potential for gains, while the risk exposure generally sits between ITM and OTM options. OTM options are the riskiest as they can expire worthless if the underlying price doesn’t reach the strike price. However, if the price movement aligns with the strike, OTM options can yield significant gains relative to their cost.

Each type of option ultimately offers unique characteristics that align with different trading styles and objectives. Whether you're aiming for capital preservation, hedging, or high potential gains, understanding these differences can help tailor your strategy to market conditions and personal goals.

Which is best for crypto option traders?

The best choice depends on your risk tolerance, market outlook, and trading objectives:

• ITM options: Ideal for traders wanting stability and higher likelihood of lucrative outcomes.

• OTM options: Better suited to those who prefer higher risk with the potential for outsized returns.

• ATM options: Suitable for a balanced approach, offering moderate cost with reasonable payoff prospects.

Final words and next steps

Mastering ITM, OTM, and ATM crypto options gives crypto traders the flexibility to navigate markets with tailored strategies that match their risk and reward preferences. ITM options provide a safer but higher-premium choice, OTM options allow for high-reward opportunities at the expense of greater risk, while ATM acts as the middleground where there's a balanced amount of risk and reward. As you explore crypto options trading, start with a strategy aligned with your market outlook and risk tolerance to gain confidence in this dynamic trading space.

Keen to give crypto options trading a try? Check out our variety of Bitcoin options. Alternatively, you can also read up on strategies involving ITM and OTM options with our guide to the options wheel strategy and put call parity arbitrage.