In-the-Money (ITM) vs. Out-of-the-Money (OTM) Vertical Spreads

Option traders tend to toss around the terms out of the money (OTM) and in the money (ITM) a lot. And although the definitions are relatively simple, the impact each has on trade results can be quite complex.

In-the-money vs. out-of-the-money vertical spreads: put and call examples

Suppose you have a bullish bias on a stock or index, and you’re contemplating selling an OTM put vertical spread. Is there something wrong with buying ITM verticals when you’re bullish? Well, no—and yes.

First, the no. When you sell an OTM put vertical, that’s synthetically the same profit and loss profile as buying an ITM call vertical with the same strike prices. Both verticals are theta positive, meaning as time passes, all else being equal, time decay works for you rather than against you.

For the most part, the same risk means the same reward. Say you pick your favorite stock XYZ that’s trading at $90. You decide to sell the Sep 80/85 put vertical by selling a Sep 85 put and buying a Sep 80 put for a net credit of $1.50. This has the same risk/reward as buying the Sep 80/85 call vertical, which is buying a Sep 80 call and selling a Sep 85 call for a $3.50 debit.

How’s that? The max profit for the call vertical is the width of the spread, which in this case is $5 minus the $3.50, or $1.50, not including transaction costs. You’ll only get this when the stock price is above $85 at expiration. The max loss for the call vertical is $3.50, which you’ll see when the stock is less than $80 at expiration. Note that the 85 call is at high risk of early assignment because it’s ITM. In this case, you’d likely need to exercise the long call to flatten the short position. Keep in mind, short options can be assigned at any time up to expiration regardless of ITM condition. 

Now let’s look at the max profit and loss from selling the put vertical. Your max profit will be the premium, $1.50, which again you’ll keep if the stock price stays above $85 through expiration. The max loss will be $5 – 1.50, or $3.50.

If XYZ goes to zero, the max loss on either spread is the same ($350). If XYZ goes to $100, the profit on either is $150. And breakevens? They’re the same—both at $83.50. That’s why the profit and loss profile for the short put vertical and the long call vertical are synthetically the same. One is created with calls; the other with puts. But as far as risk/reward goes, they’re the same.

Try it for yourself using the paperMoney® virtual platform. From the Analyze tab, enter a symbol and under Add Simulated Trades, expand the Option Chain of the underlying. Select Vertical from the Spread menu, then choose the put spread you’re considering (see figure 1). Next, select Analyze sell trade and then Vertical. Once the order window is populated with the trade details, select the Risk Profile subtab. Do the same with buying the call spread for the same strikes. Compare the two risk profiles. You’ll find that they’re identical.

In-the-money vs. out-of-the-money vertical spreads: What’s the difference?

So, what’s the difference? It has nothing to do with theory and everything to do with practical trading. It’s really about the “tradability” of each.

Liquidity. OTM verticals are typically easier to trade because they tend to be more liquid. That’s because more retail participants trade them. And because option traders can sell the OTM call options against their stock position to generate income, there’s just more activity in them all around. They’re also less expensive than ITM spreads. The combination of price plus activity translates into tighter markets for OTM verticals.

Cost of trade. If you’re lucky and your short OTM put vertical expires worthless, that’s it. It’s done. You keep the premium and move on to the next trade. But in this case, if your ITM call vertical is still ITM at expiration, your broker may automatically exercise the long option in your vertical spread on your behalf to ensure you get the shares you’re entitled to. If the short part of the long vertical is also ITM, then it’ll also be automatically exercised too, requiring you to cough up the shares. Of course, the shares from the long option can be used to deliver the shares for the short option. Many traders prefer to avoid exercise and assignment and close the position before expiration. It’s important to remember that anytime a short option is at, in, or even out of the money, there’s some risk of being assigned at any time—even well before expiration. Keep in mind, in some market conditions, the trader may not be able to trade out of the position.

Ultimately, you decide which way to go. Although mathematically there’s no difference between OTM and ITM verticals, there’s a reason more traders gravitate to OTM. Given the difference in liquidity and cost, sometimes two alternatives that seem similar at first glance can have detailed differences.