Options trading offers a versatile toolbox for investors and traders, allowing them to speculate on price movements, hedge existing holdings, and generate income. However, navigating the world of options requires a solid understanding of key concepts. This blog delves into three fundamental terms: In the Money (ITM), At the Money (ATM), and Out of the Money (OTM). By grasping these concepts, you'll be better equipped to make informed decisions in your options trading endeavours.
What are options contracts?
Before exploring ITM, ATM, and OTM, let's establish a basic understanding of options contracts. An option contract grants the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset (stock, index, etc.) at a specific strike price by a specific expiry date.
- Strike Price: This is the predetermined price at which the buyer can exercise the option to buy (call) or sell (put) the underlying asset.
- Expiry Date: This is the last date by which the option contract can be exercised. Options contracts that are not exercised before expiry expire worthless.
What is ITM in options trading?
An ITM option holds intrinsic value. This means the option has the potential to be exercised profitably at the current market price of the underlying asset. Here's a breakdown for calls and puts:
- ITM Call Option: An ITM call option has a strike price lower than the current market price of the underlying asset. For example, if a stock is currently trading at $100, and you hold a call option with a strike price of $90, the option is ITM. You could exercise the option and immediately buy the stock for $90 and sell it in the market for $100, profiting $10 per share (excluding option premium paid).
- ITM Put Option: An ITM put option has a strike price higher than the current market price of the underlying asset. For instance, if a stock is trading at $80, and you hold a put option with a strike price of $90, the option is ITM. You could exercise the option and sell the stock (which you don't necessarily own) for $90 and buy it in the market for $80, profiting $10 per share (excluding option premium paid).
Key points about ITM in options trading
- Intrinsic Value: The difference between the strike price and the current market price of the underlying asset determines the intrinsic value of an ITM option.
- Time Value: ITM options can also have time value remaining if there's time before expiry. Time value reflects the potential for the underlying asset price to move further in your favour before expiry.
- Exercise vs. Holding: While ITM options can be exercised for immediate profit, holding them until expiry allows you to potentially benefit from further price movements in the underlying asset.
What is an ATM in options trading?
An ATM option has a strike price equal to the current market price of the underlying asset. At this point, the option has no intrinsic value because you can't buy or sell the underlying asset for a profit by exercising the option immediately. However, ATM options hold the most significant time value.
- Time Value Potential: Since the underlying asset price can move up or down, ATM options have the greatest chance of becoming ITM before expiry, offering potential profit through exercise or selling the option at a higher price if the market moves favourably.
- Higher Premium: ATM options typically command a higher premium compared to ITM or OTM options due to their higher time value and potential for profitability.
What is OTM in options trading?
An OTM option has a strike price higher than the current market price for call options or lower than the current market price for put options. OTM options currently hold no intrinsic value as exercising them wouldn't be profitable. However, they offer the potential for high returns if the underlying asset price moves significantly in your favour before expiry.
- Higher Risk, Higher Reward: OTM options are generally cheaper than ITM or ATM options due to their lower initial premium. However, they carry a higher risk of expiring worthless if the underlying asset price doesn't move enough in the desired direction before expiry.
- Speculative Potential: OTM options are often used for speculative strategies, where traders anticipate a significant price move in the underlying asset. If the price movement occurs, the option can become ITM and offer substantial profits.
How to choose between ITM, ATM, and OTM?
Selecting between ITM, ATM, and OTM options depends on your trading goals and risk tolerance:
- Investment Time Horizon: ITM options are suitable for shorter time horizons as they already have intrinsic value and potentially less time value decay. OTM options, with their lower upfront cost, might be better for longer time horizons if you anticipate a significant price movement.
- Risk Tolerance: ITM options offer a lower risk of expiring worthless but also come with a higher initial cost. OTM options are cheaper but carry a higher risk of expiring without value. Choose an option that aligns with your risk appetite.
- Market Volatility: In volatile markets, OTM options can offer higher potential returns if the price moves sharply in your favour. However, in stable markets, ITM or ATM options might be preferable due to their higher likelihood of profitability.
- Trading Strategy: Your overall trading strategy also plays a role. ITM options can be used for income generation through covered calls or cash-secured puts. ATM options might be suitable for straddle or strangle strategies that capitalise on high volatility. OTM options are often used for directional bets or spreads that aim to profit from significant price movements.
Examples of ITM, ATM, and OTM
Here are some illustrative scenarios:
- Investor A believes a stock will experience a moderate price increase in the next few months. They might choose an ITM call option with a slightly lower strike price to benefit from both intrinsic value and some time value decay.
- Investor B is bullish on a stock's long-term prospects but has limited capital. They might opt for an OTM call option with a lower upfront cost. However, they understand the option might expire worthless if the stock price doesn't rise significantly before expiry.
- Trader C expects a stock to experience high volatility in the coming weeks. They might choose an ATM straddle (buying both a call and a put option with the same strike price and expiry) to profit from the price moving significantly in either direction.
Beyond the basics
While ITM, ATM, and OTM are fundamental concepts, here are some additional factors to consider when trading options:
- Greeks: These are metrics that measure how an option's price reacts to changes in underlying asset price, volatility, time to expiry, and interest rates. Understanding Greeks can help you make more informed decisions.
- Option Liquidity: Choose options with good liquidity to ensure you can easily enter and exit your positions without significant bid-ask spreads impacting your profits.
- Implied Volatility (IV): This metric reflects the market's expectation of future volatility for the underlying asset. Higher IV options are generally more expensive but offer the potential for higher returns.
Mastering the options lingo
Understanding ITM, ATM, and OTM options is a foundational step in options trading. By considering your investment goals, risk tolerance, and market conditions, you can choose the most appropriate option type for your trading strategies. Remember, options trading involves inherent risks, so thorough research, proper risk management, and potentially seeking guidance from a qualified financial advisor are crucial before entering the options market.
Bonus Tip: Utilise online options calculators or option chains provided by brokerage platforms to visualise option prices, potential profits and losses, and Greeks for different strike prices and expiry dates. This can help you make informed decisions when selecting options contracts.
Disclaimer: This blog is for informational purposes only and should not be considered financial advice. Always conduct your own research and due diligence before making any trading decisions.
