A Discussion on ATM, ITM, and OTM Options, What to do With Them and Why

00;00;00;00 - 00;00;47;14

Kevin Hamilton

e account at least was around: 2010

00;00;47;16 - 00;01;21;29

Kevin Hamilton

Until this moment, I had really just been trading through the website at my bank. So having an app or having a real brokerage trading app was completely new. So the following week I went all in on Thinkorswim. I studied it every single day. The platform options, trading everything. Stock screeners, different stock analysis, including their own analysis reports. And as part of the platform, there was a section in there where market makers would get on and talk.

00;01;21;29 - 00;01;51;04

Kevin Hamilton

And one particular section is where I spent a lot of time and buy a lot of time. I mean, imagine 4 hours per night, like every night from the time I came home from work to basically after midnight, sitting there with my laptop listening to this show called Swim Lessons. This was the only one, I think, that was recorded, which was good because I could listen to it at night.

00;01;51;04 - 00;02;17;03

Kevin Hamilton

Most of the other talks I couldn't really catch because they would be during market hours and I was at work. So there was one particular episode on swim lessons that I've come back to kind of over and over again in my mind. And I remember it quite well because at the time, while I was listening to it, I was thinking, Man, that is a terrible idea.

00;02;17;05 - 00;02;53;29

Kevin Hamilton

And then I tried it out myself. From TiVo, it is Yield Guide, a show about conquering the markets and building personal wealth. I'm Kevin Hamilton. And in each episode we go deep into strategies, stories and tools that I've used and continue to use to build wealth. On the show today, I'm going to discuss what it means for stock options to be considered in the money, at the money or out of the money.

00;02;54;01 - 00;03;25;16

Kevin Hamilton

All right, so I know what you're thinking. A couple of market makers would probably not propose terrible ideas in swim lessons on the Thinkorswim platform from TD Ameritrade, a very big institution. And to be fair, it was and is still to this day an excellent idea. So in a nutshell, according to this strategy, you would sell out of the money call spreads on the S&P 500 ETF spy as a portfolio enhancement technique.

00;03;25;19 - 00;03;52;29

Kevin Hamilton

Okay. I said a lot there. Let's break this down a little bit. That is, if your portfolio is correlated to CPI, then you would sell call spreads on spy. Now what does that mean? Correlated means if your portfolio behaves similarly to CPI. So we could say that a portfolio roughly correlates to the index or ETF that holds the majority of the stocks in your portfolio.

00;03;53;02 - 00;04;20;09

Kevin Hamilton

In this in this example, it's CPI, but it could be that your portfolio is made up of technology stocks, in which case Kuku or XLK, the technology sector ETF would be a better proxy. Now you might be thinking that's probably not very accurate and right off the bat, without putting really any thought into it and with a small number of stocks especially, it isn't very accurate.

00;04;20;09 - 00;04;45;10

Kevin Hamilton

But we can make it better. We can actually look at the beta value for each stock and then adjust the portfolio's overall beta by adjusting the stocks so that the portfolio as beta matches that of the ETF. This is beta weighting and it is commonly used to determine how big of a hedge you would buy in order to hedge a percentage of your portfolio.

00;04;45;12 - 00;05;15;26

Kevin Hamilton

It isn't perfect and you can definitely experience times when the correlated ETF moves one way and your portfolio moves the other, and that is due to simply the specific risks that you're taking on by having your portfolio, you know, with a subset of the stocks that are in the overall ETF. From there, if you want to go one level deeper, you could determine how many spy equivalent deltas you're going long in your portfolio.

00;05;15;29 - 00;05;46;10

Kevin Hamilton

And then sell a percentage of those deltas by selling the call spreads. Okay. So touching on this term enhancement really quick, it is an enhancement strategy. This particular strategy to sell call spreads on this idea of a matching or correlated ETF or ETF proxy because if spy in this case were to trade flat, then it is expected that your portfolio would trade flat, but you would make money on the options that you sold.

00;05;46;10 - 00;06;17;11

Kevin Hamilton

So it's an enhancement to what otherwise would be your normal returns. So, you know, this all begs the question of why, right. We we can easily get lost in the force here. So let me just ask, like, why would anyone want to sell call spreads on an ETF like this? Right. A lot of planning goes into this. The strategy is not a speculation on the ETF going down in any way, which is what most people you know, sort of think about when they think about selling call spreads.

00;06;17;13 - 00;06;48;12

Kevin Hamilton

So let's say that we sell call spreads on SPI and we're wrong. We sell a bunch of spreads and the ETF goes up in value, then we lose money. But our portfolio should be going up with the ETF because we established that they're correlated. So if the call spreads are losing, the portfolio is winning and we're still making money, but only if we don't sell too many call spreads.

00;06;48;15 - 00;07;20;03

Kevin Hamilton

And that's the trick. You probably can't get granular enough to sell a fraction of the value in call spreads on each individual stock in your portfolio. In doing so, even if you could, is time consuming and not very efficient. Hence this very complicated strategy emerges. The goal here let's not lose sight of the goal either to realize an income, the premium from selling the call spreads in the first place.

00;07;20;03 - 00;07;54;03

Kevin Hamilton

So it truly is an enhancement to what otherwise is just a long portfolio strategy, a dollar cost average strategy into this set of stocks. And then we want to enhance that by selling out of the money call spreads. Okay. So I'm going to defend my my original claim a little bit here about what a terrible idea this is, because at the time we were in an extended bull market and every month it seemed the market was going to go up more than 1%.

00;07;54;03 - 00;08;16;21

Kevin Hamilton

And so every month, month after month, the call spreads in this case were wiped out. And that's sort of what happened to me over the course of several months when I was trying this strategy. I remember looking at the daily chart several times and the market was so bullish. You had a really hard time thinking that it would not be up another 1%.

00;08;16;24 - 00;08;57;21

Kevin Hamilton

Basically, as soon as I sold those call spreads and 1% over the course of a month in in that time in an extremely bullish market, you know, because you're selling these spreads out they have about 30 to 35 days expiration. It happened almost every month. But I tried it anyway and I lost over and over and over again on that enhancement strategy until I just stopped, which is unfortunate because I also abandoned this idea of selling options, which today has become the cornerstone of all of my investing and has a huge component of yield or income investing.

00;08;57;24 - 00;09;30;10

Kevin Hamilton

Now, that strategy is one where we sell out of the money options. Whether you're buying or selling options, an option can really be in one of three states at any given time. It can be either in the money, at the money or out of the money. Okay, a quick sidebar here on intrinsic value. So before we get into those, you have to understand intrinsic value and extrinsic value.

00;09;30;10 - 00;09;57;00

Kevin Hamilton

And these are two very, very confusing terms. I have to admit. Even, you know, now when you take this term outside of the options market, I still get a little bit confused about it. We're really fast. Let's think about ice cream. Okay. Ice cream. You scream. We all scream for ice cream. We love ice cream. Now, think about maybe a time when you were a kid.

00;09;57;03 - 00;10;28;29

Kevin Hamilton

You have a coupon that allows you to buy your favorite ice cream. And this coupon lets you buy the ice cream for less money than it usually costs. The intrinsic value then of this coupon is the money that you save. If the ice cream costs a dollar but the coupon saves you $0.10, then that coupon has an intrinsic value of $0.10 in stock options.

00;10;29;02 - 00;11;05;04

Kevin Hamilton

Intrinsic value works very, very similarly. If you have an option to buy a stock at a lower price than what it's worth right now, the difference in these prices is like the money you save with your ice cream coupon. That's the intrinsic value of the stock option. Another way to say this is that if you exercised the option right now to buy the stock, so you buy 100 shares at the strike price of the option and then sell it on the market immediately.

00;11;05;06 - 00;11;32;21

Kevin Hamilton

The intrinsic value is the amount of money that you would make from that transaction. All right. First up in the money options, if the option has intrinsic value, then we say it is in the money you will be paid. If you exercise in the money, call options have a strike price that is less than the current price of the stock.

00;11;32;23 - 00;11;55;27

Kevin Hamilton

Put options that are in the money have a strike price that is greater than the current stock price. So if I have a call option that says I can buy the stock at $9 and the stock is currently $10, then it is like that coupon again, I can buy it for a discount to the market price. In this case, then the intrinsic value is $1.

00;11;55;29 - 00;12;24;07

Kevin Hamilton

Okay, so what is the primary use of in the money options or when would I think about using them? I feel like in the money options are primarily used as hedges or for leverage. If we want to have long exposure to a stock, then we can buy call options. We believe the price will go up. If we want short exposure, then we can buy put options that we believe the price will go down.

00;12;24;09 - 00;12;52;23

Kevin Hamilton

So I could hedge my portfolio by buying put options right. We call that a hedge because I'm paying money instead of selling the stock that I own, which would cause me to have tax consequences or possibly other consequences in the account. And I also wouldn't participate from any upside. I could hedge part of the position by maybe buying one or to put options.

00;12;52;25 - 00;13;27;15

Kevin Hamilton

Either way, it is usually best to buy in the money options as they have a greater probability of being worth something in the future. Since they're already in the money, they have intrinsic value. Okay. The other way to use long options is for leverage. If I wanted to leverage up a long position, which I recently did when I was trading Marathon digital in a are a I was losing money on put options that I had sold.

00;13;27;17 - 00;13;54;24

Kevin Hamilton

I was a signed a bunch of shares and the stock kept going down. I wanted to increase my long position without buying more shares. And the way that I did that was that I converted the shares that I was holding into Leap's long dated call options. So go out over a year, maybe a year and a half and you can buy call options out there.

00;13;54;24 - 00;14;20;27

Kevin Hamilton

In this case, I was able to buy call options and only pay around $3 for the call options when the stock was trading for $7. So that's the leverage I can get exposure to. Instead of 100 shares for $700, I get exposure to 100 shares for only $300. So that allowed me to leverage up the position and get ready for a rebound.

00;14;20;29 - 00;14;48;08

Kevin Hamilton

Now, there is a ton of risk in doing something like this, so I'm not advocating that this is a strategy for anyone, but that is sort of how you can imagine using options, going long, buying options, buying leafs in order to gain leverage in your portfolio. Look at the money options. At the money options are usually kind of boring.

00;14;48;08 - 00;15;11;24

Kevin Hamilton

I feel like these options have a strike price that is very close to the price that the stock is trading at. It's rarely perfect, but if it's around there, we kind of call the options out the money. They could easily go in the money at any minute or they could expire worthless. These have effectively a 50% probability of being worth something at expiration.

00;15;11;27 - 00;15;38;05

Kevin Hamilton

So they're kind of like a stock trade. I don't trade these very often because if I'm buying options, I would buy in the money options. And if I'm selling options, I would sell out of the money options. One thing to note here is that your brokerage account may not like it very much If you have sold a call spread, for example, you're short a vertical call spread and the short strike is at the money or close to going in the money.

00;15;38;08 - 00;16;12;26

Kevin Hamilton

This is because if on expiration, the strikes of the spread are split, then you could be short and in the money call option with unlimited risk because of the long option expired worthless. So because of the nuances around closing options on expiration day and to avoid weird situations like that or situations where your brokerage wouldn't know what you wanted to do because the stock price settled in between the strikes of the spread, they may close spreads early on expiration date.

00;16;12;26 - 00;16;38;05

Kevin Hamilton

If you're ever in doubt about this or you have a spread that is close, you want to communicate with your brokerage about it or or manage that position yourself before your brokerage closes it on your behalf. So not a lot to say about at the money options. Those are going to be options are roughly 50 delta. The strike price is very close to the current price of the stock now out of the money options.

00;16;38;05 - 00;17;04;28

Kevin Hamilton

So we started this whole conversation talking about out of the money options. These are options that you wouldn't exercise because it would be cheaper for you to let them expire worthless. These options have zero intrinsic value, so the only value that they have is due to their expiration date. They have what's called time value, which is an extrinsic value.

00;17;05;00 - 00;17;36;04

Kevin Hamilton

They also have a lower probability of being worth something in the future since they have no intrinsic value today. Therefore, these are best to sell to other people who want to bet on big changes to the underlying stock value. In fact, if you think about now, the only value in these options is the time value. You can easily see that if you buy an out of the money option with zero days to expiration, that is an option expiring today.

00;17;36;06 - 00;18;05;04

Kevin Hamilton

Then the only value that it has are the remaining hours of the day. What a gamble. You're going to pay money, which by the way, is risk adjusted for the seller. It's a risk adjusted for the seller based on the volatility to bet that the underlying index or ETF will move hard and fast. Like right now, it really seems crazy when you think about it that way.

00;18;05;07 - 00;18;49;08

Kevin Hamilton

But zero is zero day to expiration it options zero disease are explored loading in popularity. And I have to tell you, big banks would love to sell you as many of these as they possibly can. If it's good for big banks, it's good for me. I love selling out of the money options as well. If you're looking to sell options, which of course you are, because you're listening to a podcast where generating yield and a primary source of income is from selling options, and then you've found the options you want to sell sell out of the money options, how far out of the money and how long of an expiration date are entirely up to

00;18;49;08 - 00;19;14;02

Kevin Hamilton

you. A good place to start is around 30 delta and 35 to 45 days to expiration. Okay, I spoke about time value of money that actually has a name in one of the Greeks. I'm sure you're already aware of it. We call it theta and it is the measure of the change of the options price due to the passage of time.

00;19;14;05 - 00;19;46;28

Kevin Hamilton

And it's usually expressed in a sort of a daily value like -$0.20. So all things being equal, if today's slips by this option will be worth $0.20 less tomorrow. So if there's a lot of time, let's say a year or more, then theta will be really, really low. And I just spoke about on Marathon Digital when I converted my, my shares into options for leverage, I used leaps, right?

00;19;47;00 - 00;20;13;01

Kevin Hamilton

These are very, very, very far dated options and there's a lot that can happen in a year and therefore there's a lot of extrinsic value in those options. So they behave much more like the shares than options that are expiring today. If the options expire today, theta will be much, much higher. The option will go to zero very fast.

00;20;13;01 - 00;20;46;20

Kevin Hamilton

It has to you can kind of see that there's only hours left in the day and this is the only value in this option. There's no intrinsic value. So it's going to go to zero. We typically see theta accelerate around 45 days to expiration, which is why if you're if you're just starting out selling options, looking at, you know, options that are that are pretty well out of the money, 30 delta or so and with 35 to 45 days expiration sort of gets you into that spot where theta is starting to accelerate and you profit a little more quickly.

00;20;46;20 - 00;21;09;23

Kevin Hamilton

If you were to sell Leap's options that expire in more than a year, then you're really just going to be sitting there. And if the stock doesn't change value, the leaves aren't really going to change value. You're not going to profit from the passage of time. Okay. In summary, then, if we're buying options, it is typical for investors to buy in the money options with long expiration dates leaps.

00;21;09;26 - 00;21;32;23

Kevin Hamilton

This is because it maximizes the intrinsic value and minimizes the theta decay or value lost due to the passage of time. If we're selling options, it is typical for investors to sell out of the money options with near term expiration dates in order to take advantage of the fact that they have no intrinsic value and theta decay will be faster.

00;21;32;25 - 00;21;57;13

Kevin Hamilton

Of course, there are a ton of other situations where we find investors selling in the money options or buying out of the money options. Just to keep in mind that these simple ideas of intrinsic value, extrinsic value and the theta decay, they will guide you toward putting together a robust strategy for whatever it is that you're trying to achieve.

00;21;57;15 - 00;22;23;00

Kevin Hamilton

Okay, that will do it for today. Thank you for being here, for listening to this episode for questions about today's content, please reach out to podcast at Yield Dot Guy. I would love to hear about how you are using options in your account. Please write me and let me know. Remember to join us for office hours. The schedule for that is coming.

00;22;23;02 - 00;22;29;12

Kevin Hamilton

Here's to your financial success. Wherever you are along the journey.