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Key Highlights
- As a trader, any option you buy will come under the categories of In-The-Money (ITM), Out-of-The-Money (OTM), and At-The-Money (ATM).
- These categories indicate the difference between the spot price and the strike price of an option that you have bought.
- Based on these categories, you can evaluate the intrinsic value of an option and make an investment decision based on the same.
If you want to venture into FnO (Futures and Options) trading, you must learn how to estimate the intrinsic value of an option.Evaluating whether an option is In-The-Money (ITM), Out-of-The-Money (OTM) and At-The-Money (ATM), can help you determine its intrinsic value. In this blog, we will look at what ITM, OTM and ATM mean in the context of call and put options. In the end, you will be able to use this knowledge to improve your overall investment analysis.
What is a Call Option?
Before you learn about ITM, ATM and OTM, you must understand the different types of option contracts. A call option allows you to buy an underlying asset at a predetermined strike price.
Typically, a call option is bought when the buyer of the option is expecting the price of the underlying asset to grow so they have the option to buy it at a cheaper price.Another reason to buy a call option would be as insurance for when you want to sell a stock. If the stock price rises after the sale, you will be able to cash in on the gains that you could have made.
ITM, ATM and OTM for Call Options
Now, let's find out what ITM, ATM and OTM mean in terms of call option contracts.
ITM Call Options
If your call option contract is In-The-Money, it means that the strike price is lower than the underlying asset's price. For instance, if a stock's price is ₹200 and an options strike price is ₹180, the option would be said to be In-The-Money.In this case, the option contract would have an intrinsic value of ₹20, i.e. the profit that would be made if the option you own is exercised immediately.
ATM Call Options
If your call option contract is At-The-Money, it would mean that the strike price of your option is similar to or the same as the spot price at which the underlying asset is trading.For example, if an asset's spot price is at ₹20 and the strike price for the call option of this asset is also ₹20, then this option would be an At-The-Money option. The option has no intrinsic value but has a time value.Time value represents the potential of an option to increase in value before expiration.
OTM Call Options
If a call option contract is Out-The-Money, it indicates that the strike price of an option is more than the spot price.For example, if an asset's spot price is at ₹20 and the strike price for the call option of this asset is ₹22, then this option would be an At-The-Money option.In this scenario, the Out-The-Money option contract will have no intrinsic value but will have time value.
What is a Put Option?
Before diving into the meaning of ITM, OTM and ATM option contracts, let's address what a put option is.A put option, when exercised, allows you to sell a given asset at a predetermined price. When you buy a put option, you are expecting the underlying asset to fall.You can also buy a put option as insurance when you are investing heavily in a stock.
ITM, OTM and ATM Put Options
Let's look at the meaning of the put options in this context.
ITM Put Options
If your put option contract is In-The-Money, it means that the strike price for your option is higher than the underlying asset's price. For instance, if a stock's price is ₹200 and an options strike price is ₹220, the option would be said to be In-The-Money.This option contract would have an intrinsic value of ₹20, meaning the profit made if the option you own is exercised immediately.
ATM Put Options
If your put option contract is At-The-Money, it would mean that the strike price of your option is similar to or the same as the spot price at which the underlying asset is trading.For example, if an asset's spot price is at ₹20 and the strike price for the call option of this asset is also ₹20, then this option would be an Out-The-Money option. The option has no intrinsic value but has a time value.
OTM Put Options
If a put option contract is Out-The-Money, it indicates that the strike price of an option is lower than the spot price.For example, if an asset's spot price is at ₹20 and the strike price for the put option of this asset is ₹18, then this option would be an Out-The-Money option.The Out-The-Money option contract has no intrinsic value but will have time value.
Why traders analyse ATM, ITM, and OTM
Traders analyse ATM, ITM, and OTM options for various key reasons:
- ITM: These options have higher inherent risk due to their significant intrinsic value. A small adverse price movement can quickly erode profits.
- OTM: While cheaper, they carry a higher risk of expiration.
- ATM: Offer a more balanced risk-reward profile, but their value is influenced by both time decay and price movement.
- ITM: These contracts offer immediate profit potential if exercised.
- Risk Assessment:
- Profit Potential:
- OTM: Have higher leverage, meaning a small price move can result in significant gains.
- ATM: These contracts provide a blend of both immediate and potential profit.
- ITM: These contracts are suitable for traders seeking immediate profits or hedging existing positions.
- OTM: OTM contracts are ideal for traders with high-risk tolerance and a strong directional bias.
- ATM: ATM contracts can be used in various strategies, including spreads and straddles.
- Analysing the volume and open interest of ATM, ITM, and OTM options can provide insights into market sentiment and potential price movements
- Trading Strategy Formulation:
- Market Sentiment:
How do premiums differ across ATM, ITM, and OTM
Option premiums are influenced by several factors, including:
- ITM: Highest intrinsic value, leading to higher premiums.
- OTM: No intrinsic value, resulting in lower premiums.
- ATM: Minimal intrinsic value, contributing to lower premiums.
- OTM: Generally higher time value due to greater potential for price appreciation.
- ITM: Lower time value as most of the premium is attributed to intrinsic value.
- ATM: A balance of intrinsic and time value.
- Higher volatility generally increases premiums across all strike prices.
- Intrinsic Value:
- Time Value (Theta):
- Volatility (Vega):
ITM, OTM and ATM Options: All You Need To Know
Understanding the meaning and intricacies of ITM, OTM, and ATM options is crucial for successful options trading. By carefully considering your risk tolerance, market outlook, and trading strategy, you can effectively utilise these concepts to make informed decisions and potentially profit from the options market.Remember to always practice risk management and stay disciplined in your approach. Also Read: 13 Common Stock Trading Mistakes to Avoid
FAQS - FREQUENTLY ASKED QUESTIONS
What is the time value of an option?
Time value is the portion of an option's premium that is not attributable to its intrinsic value. It represents the potential for the option's value to increase as time passes.
Which type of option is the best: ITM, OTM, or ATM?
The best type depends on your trading strategy and risk tolerance.
How do ITM, OTM, and ATM options affect option pricing?
ITM options have higher intrinsic value, so they are generally more expensive. OTM options have lower intrinsic value and are cheaper. ATM options have a mix of both intrinsic and time value.
Can an option change from ITM to OTM or vice versa?
Yes, as the underlying asset's price fluctuates, an option can transition between ITM, OTM, and ATM states.
What is time decay in options, and how does it affect ITM, OTM, and ATM options?
Time decay is the gradual loss of an option's value as it approaches its expiration date. It affects all options, but it can be more significant for OTM options.
What is the difference between intrinsic value and time value?
Intrinsic value is the immediate profit or loss if the option is exercised. Time value is the potential for the option's value to increase before expiration.
How can I use ITM, OTM, and ATM options in my trading strategy?
You can use these concepts to build various strategies, such as buying ITM options for immediate profit, selling OTM options for premium income, or using ATM options for a balanced approach.
Are there any risks associated with trading ITM, OTM, and ATM options?
Yes, all options trading involves risk. ITM options can be more expensive, OTM options can expire worthless, and ATM options can be affected by both time decay and market volatility.
How can I manage risk when trading options?
Use stop-loss orders to limit potential losses. Diversify your portfolio. Stay updated on market news and economic events.
What are some common mistakes made by options traders?
Overtrading, not understanding the underlying asset, ignoring time decay, and not having a clear trading plan can be some common mistakes that can be made.
The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.
