For traders venturing into the world of options, comprehending the distinctions between In The Money (ITM) and Out Of The Money (OTM) options is crucial. These terms hinge on the concepts of intrinsic value and time value, each influencing an option’s premium. This article will delve into in-the-money vs. out-of-the-money options, providing clear examples and insights to empower your trading decisions.
We frequently encounter the terms ‘in the money’ (ITM) and ‘out of the money’ (OTM). These terms revolve around the relationship between an option’s strike price and the underlying asset’s current market price. The strike price represents the cost at which an option holder can either purchase or sell the asset, depending on whether they possess a call or a put option. A call option grants the holder the right to buy the asset, while a put option affords the right to sell it.
In The Money vs Out Of The Money Options
An option is considered ‘in the money’ when it possesses intrinsic value, signifying that its exercise would yield a profit. A call option falls into the ITM category when its strike price is lower than the asset’s current market price. This is because the option holder can acquire the asset at a more favourable rate than the prevailing market price. Conversely, a put option is considered ITM when its strike price exceeds the current market price, allowing the option holder to sell the asset at a premium compared to the market rate.
Conversely, an option is labelled ‘out of the money’ when it lacks intrinsic value, implying that its exercise would result in a loss. A call option falls into the OTM category when its strike price exceeds the current market price, compelling the option holder to pay more than the market rate to acquire the asset. In the case of put options, they are deemed OTM when the strike price is below the current market price, which means the option holder would receive less than the prevailing market rate upon selling the asset.
To provide a concise overview of the distinctions between ITM and OTM options for both calls and puts, we’ve crafted the following table:
|Option Type||In The Money||Out of The Money|
|Call||Strike Price < Current Price||Strike Price > Current Price|
|Put||Strike Price > Current Price||Strike Price < Current Price|
Investors utilize ITM and OTM options for varying purposes, each with unique traits. ITM options command higher premiums than their OTM counterparts, primarily due to their intrinsic value and reduced time value. Time value signifies the amount an option buyer is willing to pay for the potential that the option will become more profitable before it expires. ITM options are more likely to be exercised as they are already profitable. Investors opting for ITM options anticipate a relatively smaller fluctuation in the underlying asset’s price, depending on whether they hold a call or a put.
Conversely, OTM options have lower premiums because they lack intrinsic value and higher time value. They are less likely to be exercised as they are not yet profitable. Investors who opt for OTM options anticipate more significant price fluctuations in the underlying asset, depending on whether they possess a call or a put. While OTM options entail greater speculative risk, they also offer the potential for higher returns.
In The Money (ITM) Options
An ITM call option is one whose strike price is lower than the underlying asset’s current price. For instance, if the spot price of a stock is Rs. 8300, any call option with a strike price below Rs. 8300 qualifies as ITM. The NIFTY FEB 8200 CALL is an example of an ITM call option. Such options possess both intrinsic value and time value.
Out Of The Money (OTM) Options
Conversely, an OTM call option has a strike price exceeding the underlying asset’s current price. In this scenario, the entire premium consists of time value, and there’s no intrinsic value involved. For instance, if the spot price is Rs. 8300, the NIFTY FEB 8400 CALL represents an OTM call option.
At The Money (ATM) Options
An ATM call option features a strike price almost identical to the underlying asset’s current price. These options lack intrinsic value and solely comprise time value. For instance, the NIFTY FEB 8300 CALL is an ATM call option with a spot price of Rs. 8300.
In The Money (ITM) Put Options
An ITM put option has a strike price surpassing the underlying asset’s current price. Like ITM call options, these put options have intrinsic and time value. For example, the NIFTY FEB 8400 PUT is an ITM put option if the spot price is Rs. 8300.
Out Of The Money (OTM) Put Options
An OTM put option features a strike price lower than the underlying asset’s current price. These put options only encompass time value and lack intrinsic value. The NIFTY FEB 8200 PUT qualifies as an OTM put option when the spot price is Rs. 8300.
At The Money (ATM) Put Options
An ATM put option possesses a strike price almost identical to the underlying asset’s current price. Similar to ATM call options, these put options consist solely of time value. The NIFTY FEB 8300 PUT is an example of an ATM put option with a spot price of Rs. 8300.
The Components of Option Premium
An option’s premium is composed of two main elements: intrinsic value and time value. The formula is simple:
Option Premium = Intrinsic Value + Time Value
Intrinsic Value and Its Role
Intrinsic value represents the portion of an option’s premium corresponding to its immediate profitability based on the current market conditions. For a call option, the intrinsic value equals the underlying stock’s current price minus the call strike price. Conversely, for a put option, it’s the put strike price minus the underlying stock price. It’s important to note that only ITM options possess intrinsic value, while ATM and OTM options lack this component.
Understanding Time Value (Extrinsic Value)
Time value, often called extrinsic value, goes beyond intrinsic value. It’s the surplus amount over the intrinsic value and decreases as the option approaches its expiration date. This phenomenon is known as time decay. An option’s premium is influenced by the time remaining until expiration. Options with longer expiration periods tend to be pricier due to the greater time value, increasing the likelihood of favourable trade outcomes.
Conclusion: Navigating ITM and OTM with Confidence
Mastering the distinctions between ITM and OTM options is fundamental to successful options trading. Intrinsic value and time value significantly impact an option’s profitability. Armed with this knowledge, you can strategically choose the right options to align with your trading objectives and risk appetite. Whether you’re an Indian investor diversifying your portfolio or a trader seeking favourable outcomes, understanding ITM and OTM options is a vital tool in your trading arsenal.
Yes, as the underlying asset’s price changes, an ITM option can transition to OTM status.
Yes, time value is often interchangeably called extrinsic value due to its relationship with an option’s intrinsic value.
No, an option’s strike price is fixed at the contract’s inception and can’t be altered.
Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.