The Moneyness of an Option: ITM, ATM, and OTM
In the world of options trading, "moneyness" is a term you'll hear constantly. It's a simple but powerful concept that describes the relationship between an option's strike price and the current market price of the underlying asset. Understanding moneyness is crucial because it tells you whether an option has intrinsic value – the value you would get if you exercised the option immediately.
In this article, we'll explore the three states of moneyness: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). We'll break down what each of these terms means, how they affect an option's premium, and how you can use this knowledge to make smarter trading decisions.
Intrinsic and Extrinsic Value: The Two Sides of an Option's Premium
Before we dive into the different states of moneyness, it's essential to understand the two components of an option's premium: intrinsic value and extrinsic value.
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Intrinsic Value: This is the value of an option if it were to be exercised immediately. It's the amount by which an option is in-the-money. An option can never have a negative intrinsic value.
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Extrinsic Value: This is the portion of an option's premium that is not intrinsic value. It's also known as time value. Extrinsic value is influenced by factors such as the time until expiration, implied volatility, and interest rates. The more time an option has until expiration, the higher its extrinsic value will be.
Premium = Intrinsic Value + Extrinsic Value
In-the-Money (ITM): An Option with Intrinsic Value
An option is in-the-money (ITM) if it has intrinsic value. This means that if you were to exercise the option right now, you would make a profit (before taking into account the premium you paid for the option).
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For a call option, this means the strike price is below the current market price of the underlying asset. For example, if you own a call option with a strike price of $50 and the underlying stock is trading at $55, your option is $5 in-the-money. This is because you have the right to buy the stock at $50, even though it's currently worth $55.
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For a put option, this means the strike price is above the current market price of the underlying asset. For example, if you own a put option with a strike price of $50 and the underlying stock is trading at $45, your option is $5 in-the-money. This is because you have the right to sell the stock at $50, even though it's currently worth only $45.
ITM options are the most expensive options because they have both intrinsic value and extrinsic value (time value). The deeper an option is in-the-money, the more expensive it will be, and the more it will behave like the underlying stock.
At-the-Money (ATM): On the Cusp of Profitability
An option is at-the-money (ATM) when its strike price is the same as the current market price of the underlying asset. For example, if a stock is trading at $50, a call option with a strike price of $50 is at-the-money.
ATM options have no intrinsic value. Their entire value is made up of extrinsic value (time value). These options are popular with traders who believe that the underlying asset is about to make a significant move, but they are not sure in which direction. ATM options offer the most sensitivity to changes in the underlying stock's price, making them ideal for traders who want to capitalize on short-term volatility.
Out-of-the-Money (OTM): An Option with No Intrinsic Value
An option is out-of-the-money (OTM) if it has no intrinsic value. This means that if you were to exercise the option right now, you would lose money.
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For a call option, this means the strike price is above the current market price of the underlying asset. For example, if you own a call option with a strike price of $50 and the underlying stock is trading at $45, your option is out-of-the-money.
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For a put option, this means the strike price is below the current market price of the underlying asset. For example, if you own a put option with a strike price of $50 and the underlying stock is trading at $55, your option is out-of-the-money.
OTM options are the cheapest options because their entire value is made up of extrinsic value. These options are popular with traders who are looking to make a speculative bet with a small amount of capital. However, they also have the highest probability of expiring worthless. The further an option is out-of-the-money, the cheaper it will be, but the less likely it is to become profitable.
The Relationship Between Moneyness and Delta
Delta is one of the most important of the "Greeks" – a set of calculations that measure the sensitivity of an option's price to various factors. Delta measures how much an option's price is expected to change for every $1 change in the price of the underlying asset.
The moneyness of an option has a direct impact on its delta:
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ITM options have deltas that are close to 1.0 for calls and -1.0 for puts. This means that for every $1 change in the underlying asset, the option's price will change by almost the same amount. A deep in-the-money option will behave very similarly to the underlying stock.
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ATM options have deltas that are close to 0.50 for calls and -0.50 for puts. This means that for every $1 change in the underlying asset, the option's price will change by about $0.50. ATM options are the most sensitive to changes in the underlying stock's price.
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OTM options have deltas that are close to 0. This means that for every $1 change in the underlying asset, the option's price will change very little. The further out-of-the-money an option is, the less sensitive it will be to changes in the underlying stock's price.
How Moneyness Affects Your Trading Strategy
The moneyness of the options you choose to trade will have a significant impact on your potential risk and reward. Here's a breakdown of how you might use different states of moneyness in your trading:
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ITM Options: These are a good choice for traders who want a higher probability of success and are willing to pay a higher premium. They are often used in strategies where the trader wants to replicate the performance of the underlying stock with less capital, such as a covered call strategy.
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ATM Options: These are ideal for traders who are looking to capitalize on short-term volatility. They offer the most bang for your buck when it comes to sensitivity to the underlying stock's price. Strategies like straddles and strangles, which profit from large price moves in either direction, often use ATM options.
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OTM Options: These are best for traders who are looking to make a speculative bet with a small amount of capital. They offer the potential for high returns, but also come with a high probability of loss. OTM options are often used in strategies like buying far-out-of-the-money calls or puts in anticipation of a major news event.
A Real-World Example: Trading Tesla (TSLA) Options
Let's consider a real-world example with a volatile stock like Tesla (TSLA). Suppose TSLA is currently trading at $200 per share. You have a bullish outlook on the company and expect the stock to rise over the next month.
Strategy 1: The Conservative Approach (ITM Call)
You could buy an ITM call option with a strike price of $190. Let's say the premium for this option is $15.00. Since the option is $10 in-the-money ($200 - $190), the intrinsic value is $10.00, and the extrinsic value is $5.00. This option has a high delta (let's say 0.80), so it will participate in a large portion of the stock's gains. If TSLA rises to $220, your option will be worth at least $30 ($220 - $190), giving you a profit of $15 per share ($30 - $15), or $1,500 per contract.
Strategy 2: The Aggressive Approach (OTM Call)
Alternatively, you could buy an OTM call option with a strike price of $210. Let's say the premium for this option is only $3.00. This option has no intrinsic value; its entire premium is extrinsic value. It has a low delta (let's say 0.30), so it will be less sensitive to small moves in the stock price. However, if TSLA has a large move up to $220, your option will be worth $10 ($220 - $210), giving you a profit of $7 per share ($10 - $3), or $700 per contract. While the total profit is less than the ITM option, the return on investment is much higher.
This example illustrates the trade-offs between ITM and OTM options. The ITM option has a higher probability of success but a lower potential return on investment, while the OTM option has a lower probability of success but a higher potential return on investment.
A Visual Guide to Moneyness
Here's a simple diagram to help you visualize the concept of moneyness:
The Path Forward
Understanding moneyness is a critical step in your journey to becoming a successful options trader. It's a fundamental concept that will help you to better understand the risks and rewards of every trade you make. In the next article, we'll take this concept a step further by exploring how to use P&L diagrams to visualize your potential profits and losses.
For now, take some time to look at an options chain and identify the ITM, ATM, and OTM options. Pay attention to how the premiums and deltas change as you move from one state of moneyness to another. This will help you to develop a deeper understanding of how options are priced and how they behave.