What Is ITM vs. ATM vs. OTM in Options?
Explore the fundamental relationship between an option's strike price and the underlying asset's market value, crucial for understanding its potential.
Options are financial contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. Understanding options involves their “moneyness,” which describes the relationship between the option’s strike price and the current market price of the underlying asset.
Understanding Option Moneyness
Option moneyness categorizes an option’s relationship to the underlying asset’s price, indicating its potential for immediate profitability if exercised. This classification helps in assessing an option’s inherent value. There are three primary states of moneyness: “In The Money” (ITM), “At The Money” (ATM), and “Out of The Money” (OTM).
An option is “In The Money” (ITM) when it would generate a profit if exercised immediately, possessing intrinsic value. Conversely, an option is “Out of The Money” (OTM) when it holds no intrinsic value, and exercising it immediately would not be profitable; these options derive their value solely from the potential for the underlying asset’s price to move favorably before expiration.
“At The Money” (ATM) describes an option where the strike price is equal to or very close to the current market price of the underlying asset. ATM options have no intrinsic value; their entire value is composed of time value, reflecting the possibility that the option could become profitable before it expires.
Moneyness for Call Options
For call options, moneyness is determined by comparing the underlying asset’s current market price to the option’s strike price. A call option’s value increases as the underlying asset’s price rises.
A call option is “In The Money” (ITM) when the current price of the underlying asset is higher than the option’s strike price. For example, if a stock trades at $110, a call option with a strike price of $100 for that stock would be ITM. Exercising this option would allow the holder to buy the stock for $100 and immediately sell it in the market for $110, realizing a profit.
A call option is considered “At The Money” (ATM) when the underlying asset’s current price is approximately equal to the option’s strike price. If a stock is trading at $100, a call option with a strike price of $100 for that stock would be ATM. While it has no immediate profit if exercised, it carries time value.
A call option is “Out of The Money” (OTM) when the current price of the underlying asset is lower than the option’s strike price. For instance, if a stock is trading at $90, a call option with a strike price of $100 would be OTM. Exercising this option would mean buying the stock for $100 when it could be purchased in the market for $90, resulting in a loss.
Moneyness for Put Options
Moneyness for put options operates opposite to call options, reflecting their nature as the right to sell an underlying asset. A put option’s value generally increases as the underlying asset’s price falls.
A put option is “In The Money” (ITM) when the current price of the underlying asset is lower than the option’s strike price. For example, if a stock trades at $90, a put option with a strike price of $100 would be ITM. This allows the holder to sell the stock for $100, even though its market value is $90, generating a profit.
A put option is considered “At The Money” (ATM) when the underlying asset’s current price is approximately equal to the option’s strike price. If a stock is trading at $100, a put option with a strike price of $100 would be ATM. Similar to ATM call options, it holds no intrinsic value but possesses time value.
A put option is “Out of The Money” (OTM) when the current price of the underlying asset is higher than the option’s strike price. For instance, if a stock is trading at $110, a put option with a strike price of $100 would be OTM. Exercising this option would mean selling the stock for $100 when it could be sold in the market for $110, resulting in a financial disadvantage.
Significance of Option Moneyness
Understanding an option’s moneyness is important for assessing its value and potential outcomes. This concept directly relates to an option’s intrinsic and time value, which together determine its premium.
Only “In The Money” (ITM) options have intrinsic value. For a call option, intrinsic value is calculated as the underlying asset’s current price minus the strike price. For a put option, it is the strike price minus the underlying asset’s current price. If this calculation yields a negative result, the intrinsic value is considered zero.
All options, regardless of their moneyness, possess time value, also known as extrinsic value, which is the portion of an option’s premium beyond its intrinsic value. This value reflects the possibility that the option could become ITM before expiration. Time value erodes as an option approaches its expiration date, a phenomenon known as time decay. “At The Money” options have the highest time value due to their balanced probability of moving either ITM or OTM.
At expiration, an option must be “In The Money” to have any value, otherwise it will expire worthless. Moneyness helps evaluate an option’s likelihood of retaining value or expiring worthless, based on the underlying asset’s price movement relative to the strike price. The premium paid for an option is lost if it expires “Out of The Money.”