What Is an In The Money Option for Calls and Puts?
Understand the crucial condition that defines an option's immediate value and potential for profit. Essential insights for informed options trading.
Options are financial instruments that provide the holder the choice, but not the requirement, to buy or sell an underlying asset at a predetermined price on or before a specific date. These contracts are frequently used by investors to manage risk or speculate on future price movements. Understanding an option’s current state and its potential value is fundamental for options trading, especially knowing if it holds immediate value based on the underlying asset’s market price.
Understanding “In The Money”
An option is considered “in the money” (ITM) when its exercise would result in an immediate financial gain. For an option to be ITM, the relationship between the underlying asset’s price and the strike price must be favorable to the option holder. This means that if the option were exercised at that moment, it would yield a profit before accounting for the premium paid for the option.
The concept of being ITM is distinct from whether an option trade itself is profitable, as the premium paid for the option contract also impacts the overall outcome. An option can be ITM but still not profitable if the premium paid was higher than its current value. However, the ITM status itself signifies that the option has a real, positive value if exercised immediately.
Call Options That Are In The Money
A call option grants the holder the right to purchase an underlying asset at a specified strike price. For a call option to be “in the money,” the current market price of the underlying asset must be higher than the call option’s strike price. This implies the holder could buy the asset at the lower strike price and immediately sell it at the higher market price, realizing a gain. The greater the difference between the market price and the strike price, the deeper the call option is ITM.
For example, consider a call option with a strike price of $50 on a stock. If the stock is currently trading at $55 per share, this call option is in the money by $5 per share. The holder could exercise the option to buy the stock at $50 and then sell it in the market for $55, effectively gaining $5 per share before factoring in the option’s cost. This positive difference represents the intrinsic value of the call option.
Put Options That Are In The Money
Conversely, a put option provides the holder the right to sell an underlying asset at a specified strike price. A put option is “in the money” when the current market price of the underlying asset is lower than the put option’s strike price. This condition allows the holder to sell the asset at the higher strike price, even though its market value is lower, resulting in an immediate profit if the option were exercised.
To illustrate, imagine a put option with a strike price of $50 on a stock. If the stock is currently trading at $45 per share, this put option is in the money by $5 per share. The holder could buy the stock in the market for $45 and immediately sell it using the option contract for $50, thereby gaining $5 per share before considering the option premium. This difference signifies the intrinsic value of the put option.
Intrinsic Value And Profitability
The “in the money” status of an option is directly linked to its intrinsic value, which is the portion of the option’s price derived from the immediate profitability of exercising it. Intrinsic value is calculated as the difference between the underlying asset’s current price and the option’s strike price, but only when this difference is favorable to the option holder. Only options that are ITM possess intrinsic value, as they are the only ones that would yield a positive return if exercised at the current moment.
This intrinsic value represents the minimum value an option could trade for, as it is the immediate gain available upon exercise. While options also have extrinsic value, often referred to as time value, which accounts for the possibility of further price movements before expiration, intrinsic value is the direct measure of an ITM option’s current worth.
The Difference Between In The Money, At The Money, and Out Of The Money
Options can exist in one of three states relative to their strike price and the underlying asset’s market price: in the money, at the money, or out of the money. An option is “at the money” (ATM) when the underlying asset’s current market price is equal or very close to the option’s strike price. ATM options have no intrinsic value and primarily consist of extrinsic value.
An option is “out of the money” (OTM) when exercising it would not result in an immediate profit. For a call option, this means the strike price is above the current market price; for a put option, the strike price is below. OTM options have no intrinsic value and derive their entire worth from extrinsic value, which diminishes as the option approaches expiration. The primary distinction among these states lies in whether the option carries intrinsic value.