In options trading, the difference between "in the money" (ITM) and "out of the money" (OTM) is a matter of the strike price's position relative to the market value of the underlying stock, called its moneyness.
An ITM option is one with a strike price that has already been surpassed by the current stock price. An OTM option is one that has a strike price that the underlying security has yet to reach, meaning the option has no intrinsic value.
A call option gives the option buyer the right to buy shares at the strike price, if it is beneficial to do so. An in the money call option, therefore, is one that has a strike price lower than the current stock price. A call option with a strike price of $132.50, for example, would be considered ITM if the underlying stock is valued at $135 per share because the strike price has already been exceeded. A call option with a strike price above $135 would be considered OTM because the stock has not yet reached this level.
In the case of the stock trading at $135, and the option strike of $132.50, the option would have $2.50 worth of intrinsic value, but the option may cost $5 to buy. It costs $5 because there is $2.50 of intrinsic value and the rest of option cost, called the premium, is composed of time value. You pay more for time value the further the option is from expiry, because the underlying stock price will move before expiry which provides opportunity to the option buyer and risk to the option writer which they need to be compensated for.
Put options are purchased by traders who believe the stock price will go down. ITM put options, therefore, are those that have strike prices above the current stock price. A put option with a strike price of $75 is considered in the money if the underlying stock is valued at $72 because the stock price has already moved below the strike. That same put option would be out of the money if the underlying stock is trading at $80.
In the money options carry a higher premium than out of the money options, because of the time value issue discussed above.
Comparing the ITM and OTM
In the money or out of the money options both have their pros and cons. One is not better than the other. Rather, the various strike prices in an options chain accommodate all types of traders and option strategies.
When it comes to buying options that are ITM or OTM, the choice depends on your outlook for the underlying security, financial situation, and what you are trying to achieve.
OTM options are less expensive than ITM options, which in turn makes them more desirable to traders with little capital. Although, trading on a shoe-string budget is not advised. Some of the uses for OTM options include buying the options if you expect a big move in the stock. Since OTM options have a lower up front cost (no intrinsic value) than ITM options, buying an OTM option is a reasonable choice. If a stock currently trades at $100, you can buy a OTM call option with a strike of $102.50 if they think the stock will reasonably rise well above $102.50.
OTM options often experience larger percent gains/losses than ITM options Since the OTM options have a lower price, a small change in their price can translate into large percent returns and volatility. For example, it is not uncommon to see the price of an OTM call option bounce from $0.10 to $0.15 during a single trading day, which is equivalent to a 50% price change. The flip side is that these options can move against you very quickly as well, though risk is limited to the amount paid for the option (assuming you are the option buyer and not the option writer).
ITM options also have their uses. For example, a trader may want to hedge or partially hedge their position. They may also want to buy an option that has some intrinsic value, and not just time value. Because ITM options have intrinsic value, and are priced higher than OTM options in the same chain, the price moves (%) are relatively smaller. That is not to say ITM option won't have large price moves, they can and do, but compared to OTM options the percentage moves are smaller.
Certain strategies call for ITM options, while others call for OTM options, and sometimes both. One is not better than another, it just comes down to what works for the best for the strategy in question. For further reading, check out the Options Basics Tutorial.