Are You In or Out of the Money?

As part of our ongoing options education series, we routinely answer questions from our reader on the basics of options trading.

Many readers have asked that we clarify the difference between strangles and straddles, so let's start with those before we get into more basics (such as the differences between in the money and out of the money options).

Strangle and Straddle Options Positions

With an options straddle position, you're simply buying a call and a put on the best stock, with both options having the same expiration date and strike price.

Say, for instance, you wanted to straddle Apple (AAPL) with options. You could buy the March 2009 100 call and the March 2009 100 put. But you must understand you're likely to pay a commission charge upon opening and closing both positions when playing a straddle.

When buying only calls or puts, you're playing a directional strategy. With the straddle, however, which includes a put and a call, you're not playing a directional strategy. Traders will use the straddle if they feel a large move is coming but remain unsure about direction.

Upcoming FDA decisions are a good example. If the news is encouraging, the underlying security is likely to jump along with the call while killing off a put premium. If the news is bad, the underlying security is likely to fall and kill off the call premium while pumping the put option.

As for the strangle, you're buying a call and a put on the best stock with both options having the same expiration date. The only difference is the strike price.

Let's use Apple again for our example.

To exercise a strangle position, you could buy the March 2009 100 put and the March 2009 95 call. But, again, to play this you'd have to pay two commissions to open and close the positions.

While I wouldn't recommend trading earnings announcements, investors use strangles to do just that. If earnings and outlook are positive, you could see a positive impact on the best stock. If earnings and outlook are horrendous, the best stock could fall rapidly. The risk to a strangle is if the stock price remains stable or falls between the strike price of the call and put option.

While this is a basic review of straddles and strangles, we'd be happy to review them further if need be. You can leave us questions below, and we'll get back to you ASAP.

Here's another question we received just this morning:

"Ian, in Options Trading Pit you mention in the money and out of the money positions? What does this mean exactly? Thanks for the service. I'm up 52% on Equity Residential puts."

Options are classified two ways: as "in the money," and as "out of the money."

Say, for example, your stock is priced at $38. A call option would be considered in the money if you bought an option with a strike price of $37.50 or less. But a call option of $40 would be considered out of the money. It just has to do with what strike price you buy and where the underlying stock market is trading at the time.

"Ian, what do you mean by 'deltas'?"

Deltas are part of the Greek methodology covered here.

How much will your option increase when the underlying stock market moves? That depends on the delta, which measures how much an option will change in relation to movement in the underlying stock market.

Every option carries its own delta, meaning one option could provide more of a gain than another option, and it's important to know.

Deltas are measured on a per-share basis. For example, a delta of 0.80 means for every dollar the underlying stock market rises, a call option would increase by 80 cents per share. But remember, when you buy an options contract, you're buying 100 shares of a best stock. So that delta of 0.80 means that for every dollar the stock increases, you make $80 per contract.

With put options, the delta will be negative. Had you bought a put instead of a call in the above example, the delta would have been listed as -0.80. That means for every dollar the stock market dropped, you'd earn 80 cents per share, or $80.

For more on options trading, we direct your attention to the following:

How to Invest in Options

How to Buy LEAP Options

Options Intrinsic Value

ETF Options Trading

Crisis Investing

Lockup Expirations

How to Trade Like a Hedge Fund: Secrets of an Options Trader

Stay tuned for more options education next week, when we'll dive into naked options trading.