04 Out-of-the-money vs. in-the-money options, which type has the potential for higher returns?

As mentioned in previous lessons, the option premium is the market price of the option contract.

The option premium is composed of two parts: intrinsic value and time value.

Intrinsic value is affected by the difference between the underlying stock price and the exercise price. Time value, on the other hand, is affected by the number of days remaining until the option's expiration date.

Options can be categorized into three types: in-the-money, at-the-money, and out-of-the-money.

In-the-money options include intrinsic value and time value. Out-of-the-money options only consist of time value.

Investors can buy call options or put options based on their judgment of the underlying stock's trend.

Then, at a certain point in time, they sell with hopes of making a profit.

Investors can also sell options first and then buy them back, attempting to profit from the transaction.

However, trading options is more complex than trading stocks.

Because it not only requires investors to determine the direction of stock prices, but also to understand how time and implied volatility affect option premiums.

First, it's the direction of stock prices.

If an investor believes that the stock will rise, he can buy call options or sell put options.

If he thinks the stock will fall, he can sell call options or buy put options.

However, if investors guess the wrong direction, they may suffer significant losses.

Let's look at a fictional example of Rabbit Company, with the current stock price of $38.

Assuming an investor purchases a call option with a strike price of $40, with an option premium of $2 per share.

This options expires on March 18, with 30 days remaining until expiration.

This options has a strike price higher than the stock price, making it an out-of-the-money options.

You might wonder why investors would buy an out-of-the-money call options without intrinsic value?

Because they believe that the stock of RabbitRabbit has a chance to rise above $40 before the expiration date.

As the stock price of RabbitRabbit starts to rise, the possibility of the call options moving from out-of-the-money to in-the-money increases, leading to a potential increase in options premium.

Conversely, when the stock price of RabbitRabbit falls or trades sideways, the chances of the call options moving to in-the-money decrease, and the options premium may decrease.

However, the options premium may not necessarily rise with the increase in stock price.

This also depends on how much time is left in the process.

As we mentioned before, time decay will continuously erode the options premium.

In other words, if the Futu stock price remains sideways, the time value of the options premium will decrease as time passes.

Even if the Futu stock price rises to $40 on the expiration day.

This call option on the rise may also be worthless because it has neither intrinsic value nor time value left.

Lastly, it is important to note that even if the Futu stock price rises, implied volatility may also cause the options premium to decline.

Implied volatility refers to the range of expected future price fluctuations of a stock in the market, and it is one of the factors that affect the options premium.

If an investor holds call options on Futu company, an increase in implied volatility may push up the options premium.

Conversely, a decrease in implied volatility may lead to a decline in the options premium.

In conclusion, investors can choose options based on their own judgment of stock price trends, time, and implied volatility.

In the next lesson, we will talk more about implied volatility in detail.