Mastering ITM, OTM and ATM in call options

Key Highlights

• In-the-money (ITM) call options provide the holder the right to purchase an underlying asset at a strike price lower than the current market price.
• These options possess intrinsic value, representing the difference between the strike price and the market price.
• ITM call options offer potential advantages for traders, such as a higher probability of profit and the ability to leverage market movements.
• This blog explores the intricacies of ITM call options, providing insights into their characteristics, advantages, risks and strategies for successful trading.

Introduction

Options trading lets investors take part in the financial markets in a flexible way. A call option gives the buyer the right to buy an underlying asset at a set price called the strike price. This right becomes useful when the stock price goes above the strike price, creating a chance to make a profit.

Exploring the basics of options trading

Options are a type of financial derivative. Their value comes from an underlying asset, usually stocks. Options contracts give buyers the choice, but not the obligation, to buy or sell a set amount of the underlying asset at a specific price, known as the strike price, during a certain time period.

Options trading offers investors flexibility. They can create strategies that match their market view and risk level. By knowing the basics of options and the different types available, traders can use options for various purposes. They can protect their current investments, make educated guesses about price changes, or earn extra income.

The role of call and put options

A call option gives the buyer the right to purchase the underlying asset at a set price, known as the strike price. This can be done on or before a specific date. Traders buy call options when they believe the asset’s price will rise.

In contrast, a put option gives the buyer the right to sell the underlying asset at the strike price by the expiration date. Put options gain value as the price of the underlying asset goes down.

Choosing to buy a call or put option depends on what the trader thinks about the market and how much risk they want to take. It is important to understand how the strike price, the price of the underlying asset and the option premium relate to each other in options trading for both types of options.

Understanding strike price and its importance

The strike price is an important part of an options contract. It is the set price at which you can buy the underlying asset if you have a call option or sell it if you have a put option.

The strike price and the market price of the underlying asset help to show if an option is in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). This distinction is known as ‘moneyness.’

Choosing the right strike price is important for success in options trading. This choice depends on factors like the trader’s view of the market, their risk tolerance and how much time is left until the options contract ends.

Decoding ITM: In-the-money call options explained

An in-the-money (ITM) call option means that the market price of the asset is above the strike price of the option. In simple terms, if you can buy the underlying asset for a lower price (the strike price) and sell it for a higher price (the market price), your option is ITM.

ITM call options have intrinsic value. This intrinsic value is the gap between the current market price of the underlying security and the strike price of the option. Traders like ITM call options because they have a better chance of making a profit at expiration if the market moves positively for them.

Criteria for an option being considered in the money

An option is called ‘in the money’ (ITM) when exercising it right away would make a profit for the holder, not counting the premium paid. For call options, this happens when the option’s strike price is below the current market price of the underlying security.

ITM options have intrinsic value. This value shows the possible profit from exercising the option. You find the intrinsic value by taking the current market price of the underlying asset and subtracting the option’s strike price.

How much an option is ITM affects its intrinsic value and its premium. The more an option is in the money, the higher its intrinsic value and premium will be.

Advantages of ITM call options for traders

ITM call options have many benefits for traders who want to take advantage of rising markets and manage their money well. Some main benefits include:

• Higher chance of profit: ITM options have a better chance of ending in-the-money compared to out-of-the-money (OTM) options, which means they are more likely to make a profit if the market goes up.
• Intrinsic value: ITM options have intrinsic value, while OTM options only have time value. This intrinsic value helps reduce losses, even if the market does not go the trader’s way.
• Leverage: Like other options, ITM call options offer leverage. This means traders can manage a bigger position in the underlying asset without putting in a lot of money. This leverage can help increase profits.

The difference between ITM, OTM and ATM options

Understanding the differences between ITM, OTM and ATM options is important for options trading. These terms are called ‘moneyness.’ They show how the strike price of an option relates to the current market price of the underlying asset.

• An in-the-money (ITM) option has intrinsic value.
• An out-of-the-money (OTM) option has no intrinsic value. Its profit depends on how the underlying security’s price moves.
• An at-the-money (ATM) option has a strike price that matches the market price of the underlying security.

Defining OTM: Out-of-the-money options

An out-of-the-money (OTM) option is a type of option where the strike price is not good compared to the current market price of the underlying asset. This means that using an OTM option does not make sense, as it would be cheaper to buy or sell the asset in the open market.

OTM options only have extrinsic value, which is also called time value. This extrinsic value goes down over time, losing the option’s value as it gets closer to its expiration date.

Even though OTM options have no intrinsic value, they can give high profit potential if the price of the underlying asset changes a lot in a good way before the expiration date. However, they also have more risk because they depend on time and changes in the market.

Understanding ATM: At-the-money options

At-the-money (ATM) options are those where the strike price matches the current market price of the asset. That price is also called the spot price. For example, if a stock costs $50, an ATM option will have a strike price of $50.

ATM options sit between ITM and OTM options. When you buy them, they have no intrinsic value. If you use the option at the current market price, you won’t make a profit or a loss.

These options can change quickly when the market moves. A small change in the price of the underlying asset can shift them into either ITM or OTM status. This makes ATM options more volatile than deep ITM or OTM options.

Factors influencing option moneyness

Option moneyness refers to how options are classified as ITM, OTM or ATM. This classification isn’t fixed. It changes based on different factors that affect an option’s value.

Market movements are a key factor. When the price of the underlying asset changes, it affects how options are classified. As this price goes up or down, options can shift between ITM, OTM and ATM. This, in turn, impacts their intrinsic value and premium.

Time decay is another important factor. As options get closer to expiration, their value slowly decreases. This process happens for all options, regardless of their current moneyness status.

The impact of market movements on option value

Market movements, especially changes in the current price of the underlying asset, have a big effect on option value. For call options, if the price of the underlying asset goes up, the value of call options usually goes up too. On the other hand, when the price of the underlying asset goes down, call options often lose value. This happens because the option to buy at a set strike price isn’t as appealing anymore.

We use a Greek option called delta to measure how much an option’s value changes with shifts in the underlying asset’s price. Knowing about delta allows traders to see how market movements might affect their options and adjust their trading plans as needed.

How time decay affects ITM, OTM and ATM options

Time decay is an important idea in options trading. It shows how the time value of an option goes down as it gets closer to its expiration date. All options are affected by time decay, whether they are ITM, OTM or ATM.

Time decay hits OTM options the hardest. Since their whole value is made up of extrinsic value, they can lose value quickly and deeply as expiration gets closer.

On the other hand, ITM options have intrinsic value, which means they are less affected by time decay. This intrinsic value helps slow down the loss of time value. But still, time decay can impact ITM options, especially when they are close to their expiration date.

Strategies for trading ITM call options

Traders use different strategies for ITM call options. Each strategy matches their goals and risk levels. Some traders buy ITM call options. This lets them gain more from rising markets. They also profit more because of the higher delta effect with price increases.

Another strategy is to sell covered call options. A trader who owns shares of the underlying asset can sell ITM call options. This helps them earn money from the option premiums. However, they might lose their shares if the option gets exercised.

When to opt for ITM call options in your trading plan

Integrating ITM call options into a trading plan means checking if they fit your market views, risk levels and financial goals. Traders often choose ITM call options when they expect the price of the underlying asset to go up.

ITM calls have a higher delta, which can boost potential gains when the asset’s price increases. But this benefit also means higher costs compared to OTM options.

So, it’s important to carefully look at the risk and reward. You should consider factors like market volatility, the time until expiration and the cost of the options contract before you add ITM call options to your trading plan.

Risk management with ITM call options

While ITM options can be beneficial, managing risk is very important. They are usually less risky than OTM options. Still, traders should set clear profit goals and stop-loss orders to control possible losses.

Spreading out across different underlying assets or options strategies can lower risk. This way, traders can avoid putting too much focus on one ITM option or asset. This helps them become less exposed to sudden market changes.

Also, it’s key to keep a close eye on trades. Traders should change their plans as market conditions change. This approach is needed to handle risks related to ITM options.

Real-life examples of ITM call option trades

Imagine a trader believes that the price of a tech stock (XYZ) will go up. The stock is now priced at $110. To take advantage of this hopeful outlook, the trader might buy an ITM call option. This option has a strike price of $100 because they expect the stock price to increase even more. Remember, these examples are just for information. They are not financial advice, and real trading results can be different.

Analyzing ITM call option scenarios in Indian markets

Consider a scenario in the Indian markets where a trader expects a rise in the price of Reliance Industries (RIL) shares, currently trading at ₹2,500. They decide to purchase an ITM call option with a strike price of ₹2,400 expiring in one month.

Scenario	Stock Price at Expiry	Option Value at Expiry	Profit/Loss (Excluding Premium)
Stock Price Goes Up	₹2,600	₹200	₹100
Stock Price Remains Unchanged	₹2,500	₹100	–
Stock Price Goes Down	₹2,400	0	-(Premium Paid)

The table above illustrates that the ITM call option’s value increases if the stock price goes up. If the stock price stays the same or drops, the option loses value or expires worthless, resulting in a loss equal to the premium paid.

Conclusion

In conclusion, knowing about ITM call options is very important for a good options trading plan. When traders learn about ITM options, they can take advantage of market changes and increase their profits. By having clear ways to spot ITM options and managing risks, traders can confidently deal with the market. Whether you are an experienced trader or just beginning, adding ITM call options to your trading plan can give you an advantage and chances for big gains.

Frequently Asked Questions (FAQs)