When Is an Option In the Money? A Simple Explanation

Options contracts provide individuals with the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific date. A fundamental concept for understanding these financial instruments is “option moneyness,” which evaluates an option’s current standing relative to the underlying asset’s market price. Comprehending whether an option is in-the-money, at-the-money, or out-of-the-money is crucial for anyone engaged in options trading.

Defining Option Moneyness

Option moneyness categorizes an option’s relationship between its strike price and the current market price of the underlying asset. There are three primary states: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). Each state indicates a different immediate value and potential for profit.

An option is considered “in-the-money” when it holds intrinsic value. Conversely, an option is “out-of-the-money” if exercising it now would result in a loss, as its strike price is unfavorable compared to the underlying asset’s market price.

An option is deemed “at-the-money” when its strike price is equal to or very near the current market price of the underlying asset. At-the-money options possess no intrinsic value. Understanding these distinctions is important for assessing an option’s profitability potential.

Calculating In-the-Money for Call Options

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 option’s strike price. This allows the holder to buy the asset at the lower strike price and sell it at a higher market price.

To calculate if a call option is in-the-money, compare the underlying asset’s current trading price to the option’s strike price. If the underlying price exceeds the strike price, the call option is in-the-money. The difference indicates the amount by which the option is in-the-money.

For example, consider a stock currently trading at $105 per share. If an investor holds a call option on this stock with a strike price of $100, the option is in-the-money because $105 is greater than $100. In this scenario, the option is in-the-money by $5 per share. Similarly, if the stock trades at $112 and the call option has a strike price of $105, the option is in-the-money by $7.

Calculating In-the-Money for Put Options

A put option provides the holder with the right to sell an underlying asset at a specified strike price. For a put option to be in-the-money, the current market price of the underlying asset must be lower than the option’s strike price. This allows the holder to sell the asset at a higher predetermined strike price.

To determine if a put option is in-the-money, compare the underlying asset’s current trading price to the option’s strike price. If the underlying price falls below the strike price, the put option is in-the-money. The difference indicates the amount by which the option is in-the-money.

For instance, if a stock is trading at $90 per share and an investor holds a put option with a strike price of $95, the option is in-the-money because $90 is less than $95. The option is in-the-money by $5 per share in this case. Another example could be a stock trading at $42 with a put option strike price of $45; here, the option is in-the-money by $3.

Intrinsic Value of In-the-Money Options

Intrinsic value represents the immediate profit an option holder would realize if they exercised their option at the current market price. This value is a direct component of an option’s total premium. Only in-the-money options have intrinsic value; at-the-money or out-of-the-money options do not.

For an in-the-money call option, the intrinsic value is calculated by subtracting the strike price from the underlying asset’s current market price. For example, if a stock is at $105 and a call option has a $100 strike, its intrinsic value is $5 ($105 – $100). Conversely, for an in-the-money put option, the intrinsic value is found by subtracting the underlying asset’s current market price from the strike price. A put option with a $95 strike on a stock trading at $90 has an intrinsic value of $5 ($95 – $90).

The total price or premium of an option consists of both its intrinsic value and its extrinsic value, also known as time value. While intrinsic value is fixed by current market conditions and the strike price, extrinsic value accounts for other factors such as time remaining until expiration and volatility.