Selling an Out-of-The-Money (OTM) Put option is when the strike price is below the current stock price.
By selling an ITM Put option, you can get more premium but you risk getting assigned.
But by selling an OTM Put option, you get a higher probability of profit but you get lesser premium.
So which is better?
And should you be selling an ITM Put option?
Or should you be selling an OTM Put option?
Let’s dive into the details.
Defining ITM & OTM Put Options
Let’s start off with where the OTM Put options are.
If you look at the chart above, you will see that the current price of the stock is at $79.62.
So all the OTM Put options are the strikes below the current stock price.
And if you look at the Option Chain, the OTM Put options will have a Delta of less that 0.50.
On the other hand, for ITM Put options, they are the strikes that are above the current stock price.
That means that all the Put option strike prices that are above $79.62 are ITM.
And the ITM Put options will have a Delta of more than 0.50.
The Main Difference Between ITM And OTM Put Options
Now, let’s examine the main difference between the ITM and OTM Put options.
And the main difference is the Extrinsic Value and Intrinsic Value of these options.
Extrinsic Value is basically the time value of the options.
And this time value will all decay to zero once the option reaches its expiration date.
If you take a look at the option chain above, you will notice that the far ITM and far OTM Put options have lower Extrinsic Value than the At-The-Money (ATM) Put option.
So it’s like a bell curve where the Extrinsic Value of the ATM is highest, and it drops off as it gets further away on both sides.
On the other hand, Intrinsic Value, doesn’t decay at all.
It’s simply the difference between current stock price and the strike price.
For example, if you take a look at the strike price of 80, you will see that the Intrinsic Value is $0.38.
That is derived by taking the strike price of 80 minus the current stock price of $79.62.
Similarly, the strike price of 90 has an Intrinsic Value of $10.38 ($90 – $79.62 = $10.38).
The key difference between ITM and OTM options is that OTM options are 100 percent Extrinsic Value only.
Whereas ITM options have a mix of both Extrinsic Value and Intrinsic Value.
Tradeoff Between ITM And OTM Put Options
So now that we know the difference between the ITM and OTM options, which is better when it comes to selling Put options?
For this, let’s refer to the respective Put option Profit & Loss graph to see the difference.
Let’s first start off with the OTM Put option:
For this example, we will be using the OTM Put option with a strike of 72.
And by selling this OTM Put option, we can received a credit of $1.45 (which equates to $145 per contract).
If you take a look at the top of the Profit & Loss graph, you can see the win-rate percentage.
So for an OTM Put option, you will notice that the win-rate will always be more than 50 percent.
So in general, selling OTM Put options have a higher win-rate compared to ITM Put options.
That means it’s much more forgiving.
And by that, it means that you can be wrong on your direction and still make money in the end.
For example, right now the current price of the stock is $79.62.
A Short Put position is generally a bullish position which means we want the stock to go up.
But because the strike price is at 72, even if the stock comes down to $72.01 at expiration, you still get to keep the full premium you received at the start.
That’s why selling the OTM Put option is much more forgiving where you don’t have to be exactly right on the stock’s direction to still make money.
However, while it has a higher win-rate, there is a tradeoff.
And the tradeoff is that it will have a lower premium received compared to selling an ITM Put option, and that means a lower Return on Investment (ROI).
So how do you calculate the ROI?
You simply calculate it like this:
(Premium Received / Strike Price) / Days to Expiration x 365 Days
So the ROI for the 72 strike price is:
($1.45 / 72) / 40 x 365 = 18.37 Percent
Now let’s compare this to the ITM Put option:
So for this, we will be using the 83 strike price:
($5.77 / 83) / 40 x 365 = 63.43 Percent
As you see, the ROI for selling the ITM Put option is significantly higher than the OTM Put option.
But there’s a tradeoff as well.
And the tradeoff is that you have a lower win-rate compared to the OTM Put option.
That means it’s less forgiving and you will have to be more accurate on the direction of the trade.
How much less forgiving?
For this, we will need to calculate the breakeven for each of the Put options.
To calculate the breakeven, you simply take the strike price minus the premium received.
So for the OTM Put option with a strike price of 72, the breakeven is:
72 – $1.45 = $70.55
That means that as long as the stock is above $70.55 at expiration, you will still make money.
As for the ITM Put option with a strike price of 83, the breakeven is:
83 – $5.77 = $77.23
As you can see, the breakeven is much higher.
That means in order to make money, the stock price must be higher than $77.23 at expiration.
So while the ITM Put option has a higher premium and ROI, you pretty much have to be right on the direction of the stock or you will lose money.
As for the OTM Put option, while you don’t make as much, you don’t have to be exactly right on the direction of the stock to make money.
Is Selling ITM Or OTM Put Option Better?
So the big question you might have now is, “Which is better?”
And the answer depends on what the stock does after you put on the trade.
For example, if you sold the OTM Put option and the stock rallies right after that, you would’ve wished you sold the ITM Put option.
But if you sold the ITM Put option and the stock tanks, then you would’ve wished you sold the OTM Put option.
So it all comes down to the direction of the stock after you placed the trade on.
Now, let’s play a little game.
I’d like you to take a look at the chart below:
In the chart above, you can see that the market is going down.
Let’s say at this point you decide to sell a Put option.
Would you sell the OTM Put?
Or would you sell the ITM Put?
If you’ve seen my last video on Short Puts, or read my previous blog post on this, you will know that I sold an ITM Put at the strike price of 300.
Most people would sell an OTM Put at maybe the strike price at 270 or even lower.
And there’s absolutely nothing wrong with selling OTM Puts.
The reason I sold the ITM Put option was because I expected the market to bounce pretty quickly.
And I based that analysis of a few bullish technical indications.
First, I saw that there was a divergence between the market and the Stochastic Oscillator.
In the chart above, you can see that the market is forming lower lows, whereas the Stochastic Oscillator is forming a higher low.
This is an indication that there is a higher likelihood that the market will be going higher than it going lower.
Next, I saw that the market had tried to break the previous low of around $285 but couldn’t and formed a Bullish Pin Bar.
A Bullish Pin Bar is a bullish candlestick pattern which also indicated that there is a higher probability of the market going up than it going down.
So because of all these bullish technical indicators combined, I expected the market to go up pretty quickly at that point.
And if you expect the market to go up pretty quickly, then selling the ITM Put would yield a higher profit.
Hence, I sold the ITM Put option.
Now, at that point in time, I had also considered selling the OTM Put at the strike price of 260.
However, the premium for that was only $5.00 (which is $500 per contract).
The ITM Put option at the strike price was going for $20.00 (which is $2,000 per contract).
I thought to myself that if the market really did rally, then it would be a waste to just sell the OTM Put option.
With the OTM Put option, I’d only be able to gain Extrinsic Value.
But with the ITM Put option, I’d be able to gain both Extrinsic Value and Intrinsic Value.
And that was how I came to the decision to sell the 300 strike price because there was an equal mix of both Extrinsic Value and Intrinsic Value.
That means of the $20.00 premium I received for selling the ITM Put, $10.00 was in Extrinsic Value and another $10.00 was in Intrinsic Value.
And what I noticed was that the range of each of the candles could easily move $5 – 7 in a day.
That means I’d be able easily to capture most of that Intrinsic Value if the market just moved that much in the next few days.
And if it took some time before moving up to at least the 300 strike price, the Extrinsic Value would have also decayed much by then.
So Should You Sell ITM Or OTM Put Options?
So here are my suggestions on when to sell OTM puts.
If the current price of the stock is still far from where you want to go Long, you can sell the OTM Put.
For example, if the current stock price is at $110 and you think that $100 is a good support area where the price will bounce.
And if you can get a decent premium and ROI for selling the 100 strike Put, then you could certainly do that trade.
Also, if you’re someone that prioritises income and having a high win-rate, then go for OTM Puts.
As for selling ITM Puts, here are my suggestions.
If you want to capture both Intrinsic Value and Extrinsic Value, then go for ITM Puts.
If you don’t mind the possibility of getting assigned on your Puts, then go for the ITM Puts.
And in terms of technical indications, it would be best to only sell ITM Puts when indicators such as the Stochastic Oscillator or RSI is showing an Oversold condition.
Good luck!
Thanks!