Out-of-the-Money or In-the-Money Spreads? How to Choose

Some options strategies have similar risk profiles. When deciding between out-of-the-money (OTM) put verticals and in-the-money (ITM) call verticals, consider liquidity and price.

https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Woman at a crossroads: OTM vs. ITM spreads and how to choose
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Key Takeaways

  • The risk profiles for selling an out-of-the-money (OTM) put vertical versus buying an in-the-money (ITM) call vertical with the same strike prices are similar
  • The max loss and max profit for both vertical spreads with the same same strike prices are also similar
  • The difference is in the liquidity, cost, and the tradability of each vertical spread

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.

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 as buying an ITM call vertical with the same strike prices. Both verticals are theta positive, meaning that 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 since it’s ITM. Because of this, you’d likely need to exercise the long call to flatten the short position. 

Remember the Multiplier!

For all these examples, remember to multiply the options premium by 100, the multiplier for standard U.S. equity options contracts. So, an options premium of $1 is really $100 per contract.

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 see 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 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 on the thinkorswim® platform, 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 are identical.

thinkorswim option chain comparing in the money and out of the money vertical spreads
FIGURE 1: COMPARING ITM AND OTM VERTICAL SPREADS. When you compare the risk profiles of an out-of-the-money put vertical with an in-the-money call vertical that have the same strike prices, you’ll find them to be identical. Chart source: The thinkorswim platform. For illustrative purposes only. Past performance does not guarantee future results.

The Same … But Different

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 the 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 credit and move on to the next trade. But the ITM call vertical has a long option that is automatically exercised and a short option that’s automatically assigned. That exercise and assignment have fees attached—potentially on each leg of the trade. That can be a big expense to trade the ITM vertical if it turns out to be a winner. You could consider closing out the position to avoid the exercise and assignment fees.

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 a nickel is worth more than a nickel, right?


Key Takeaways

  • The risk profiles for selling an out-of-the-money (OTM) put vertical versus buying an in-the-money (ITM) call vertical with the same strike prices are similar
  • The max loss and max profit for both vertical spreads with the same same strike prices are also similar
  • The difference is in the liquidity, cost, and the tradability of each vertical spread

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