In the Money (or ITM) and Out of the Money (or OTM) are the concepts and the terms used in options trading. Such trading could be in stocks, commodities, currencies, indexes, etc. Options as we know give a right or an option to the buyer to use that right to buy or sell the underlying assets at the given price. All options relate to an underlying asset. Hence, with the fluctuation in the underlying asset price, the value of an option premium and thus the total option contract value also fluctuates with the change in the underlying asset price.
Before we move on let us understand the key terms related to option contracts.
- Option Contract: It gives a right not an obligation to the buyer of the contract to buy or sell the underlying asset at the contracted price.
- Underlying Assets: All option contracts are based on or relate to any underlying asset, which could be stocks, currencies, commodities, indexes, etc.
- Asset Price: The prevailing current market price of the underlying asset while executing the contract or prices during the option period.
- Strike Price: The price at which the contract is finalized.
- Option Premium: It is the price of buying the right to buy or sell. This is called the Option Premium. The buyer has to fork out this money/premium to the option seller.
- Option Variants: The strike price of the option contract in relation to asset price could be more, less, or the same. This variation and status of strike price wrt asset price give us three variants – ITM, OTM, and ATM.
ITM, OTM & ATM
ITM: In this type of contract the strike price always remains lower or lesser than the current market price of the underlying asset. Or whenever the asset price is more than the strike price, it is an ITM option contract. In such a contract the buyer of the option makes a profit by exercising the option to buy or sell.
OTM: On the other hand, in an OTM, the underlying security is yet to reach the strike price. In other words, when the asset price is lower than the strike price. This means it has no intrinsic value. Or, such options are worthless for the buyer at the expiry.
ATM: This is the contract where both the prices, the prevailing asset price, and strike price is the same, it is called an ATM option contract.
Intrinsic Value and Time Value
All option contracts premium consists of two values – Either Intrinsic Value Plus Time Value or only Time Value. Before we further detail ITM and OTM, it is important to get a clear idea of what intrinsic and time value means.
An Intrinsic value is money by which an option is ITM. Or, in simple words, it is the profit (gross) for the trader. In a call option, therefore, the intrinsic value is the difference between the underlying asset’s price and the strike price. Since all ITM call option strike price is lower than the asset price, it always carries an intrinsic value. Similarly, in the case of a put option, the intrinsic value is again the difference between the strike price and the underlying asset price.
Talking of time value, we also call it the extrinsic value. The time value comes down as an option approaches expiry. The cost of an option (or option premium) varies on the basis of the expiry date. Options with longer duration are more expensive than the ones with shorter duration. This is because the risk for the option writer is more in longer duration options.
In the Money
ITM options are useful for traders who want an option not just with a time value, but intrinsic value as well. Since ITM options carry intrinsic value, the premium for ITM options is always more. Moreover, the price fluctuations or price volatility in ITM options are also comparatively smaller to OTM. Also, their price movement is relatively smaller in comparison to OTM.
A Call option is a right, and not an obligation, bought by a trader to buy the underlying asset at the strike price if they choose so. So in an ITM call option, the strike price is below the present share price. For instance, suppose there is a call option with a Strike price = $35. Then for the ITM option, the underlying stock price should be more than this, say $37. If the strike price is less than $35, then it would be an OTM option. A buyer usually exercises the ITM option to get the stock at less than the current share price.
In the first case, where the strike price is $35, the intrinsic value of the option would be $2. But, it is probable that the cost of the option could be more, say $3. This $3 includes $2 of intrinsic value, and rest option premium, which is nothing but the time value.
The time value or premium would increase if the expiry is more. This is because the farther is the expiry, the greater are the chances of the movement in the stock price. Such movement increases the risk for the option writer.
Coming to the Put option, investors who expect the price to drop go for such an option. Thus, an ITM put option is one where the asset price is lower than the option strike price. For instance, suppose there is put option with strike price = $26. Then it is in the money if the underlying share price is less, say $24. This is because the share price has already dropped below the strike price. A buyer usually exercises the Put ITM option to sell the stock at more than the current stock price.
There is another ITM concept, called the deep-in-the-money option. This usually refers to an option with very high intrinsic value. For example, in the above example, if the strike price of a call option is $35, but the price of the underlying asset is $55, then it is deep-in-the-money.
Out of the Money
OTM option does not carry intrinsic value rather only time value. Hence, the OTM options premium is always lesser than the ITM options. Moreover, lesser premiums and lesser capital investment in terms of margins make them very popular among the traders. An OTM option is more useful when a trader expects a big movement in the stock price. Also, they have less up-front cost than the ITM options. For example, if the current share price is $25, then a trader expecting a significant price movement, could purchase an OTM call option having a strike price of $26.
In the case of the OTM put option, the strike price is below the present stock price. For example, the strike price is $15 and the price of the underlying asset is $18.
In the case of OTM options, the buyer doesn’t exercise them because it won’t be profitable for them. Because of this, their intrinsic value is nil.
Since OTM options are cheaper, they witness a bigger percentage of gains or losses than the ITM options. For example, a movement of an OTM call option from 0.10 to $0.15 in a day means a 50% change. On the flip side, such big price movements could go against an investor as well. But, for a trader (option buyer), the risk is only to the extent of option’s cost.
At the Money
As we discussed above there is one more option variant and that is ATM. Whenever the price of both, the strike price and the asset price is the same or equals, it is said to be an ATM option contract.
Suppose, if the strike price of the call or put option is $20 and the price of the underlying asset is also $20, then it is the ATM option.
ATM put and call options’ also have zero intrinsic value because a trader can’t exercise them for a profit.
Easy Way to Remember The Terms
These various terms of the option contract together with variation in case of a call and put option, may be confusing. There is one easy way to remember what these terms are.
For a call option:
ITM option = Stock price > Strike price
At the Money (ATM) option = Stock price = Strike price
OTM option = Stock price < Strike price
Similarly, for a put option:
ITM option = Stock price < Strike price
At the Money (ATM) option = Stock price = Strike price
OTM option = Stock price > Strike price
Both these option variants, ITM and OTM, are used for different situations and expectations by the traders. Both these options have their own pluses and minuses. Since they are situation and expectation based it is not possible to say which one is better out of the two. The choice of the trader also matters a lot. A trader may consider factors such as their financial situation, objective, and expectations for the underlying security to decide on which of the two to go for.