Dopex Essentials: ATM, ITM, OTM
Trigger Warning: Simple Mathematics
Hey, welcome again to another Dopex Essentials Episode. In this article we are going to be focusing on three key terms that you need to know when trading options.
- In The Money(ITM)
- Out of The Money(OTM)
- At The Money(ATM)
Without further ado let’s dive right in!
📌In the Money
“In the money” (ITM) is an expression that refers to an option that possesses intrinsic value. ITM indicates an option has a strike price that is favorable in comparison to the prevailing market price of the underlying asset.
ITM Call Options
A call option is “in the money” if the current price of the underlying asset is higher than the strike price. The buyer could exercise their right under the option contract and buy the underlying asset for less than its current value. That means the call has intrinsic value.
If the strike price of a call option is $6 and the underlying asset is currently trading at $7, the option is ITM. The higher above $6 the price goes, the more ITM the option is and the greater its intrinsic value.
For example:
A call option with a strike price of $25 would be ITM if the underlying asset was trading at $30. The difference between the strike price and the market price is option premium.
An investor holding a call option that expires in the money can exercise it and earn the difference between the strike price and market price. Whether the trade was profitable or not depends on the investor’s total expense of buying the contract and any trading fees on the exchange.
ITM Put Options
A put option is ITM if the price of the underlying asset is lower than the strike price. The buyer could exercise their right under the option contract and sell the underlying asset for more than its current value. This means the put has intrinsic value.
For example:
If the strike price of a put option is $6 and the underlying asset is currently trading at $3, the option is ITM. The lower below $6 the price goes, the more ITM the option is and the greater its intrinsic value.
ITM doesn’t necessarily mean the trader is making money though. When buying an ITM option, the trader will need the option’s value to move farther ITM to make a profit. In layman’s terms, investors buying call options need the price of the underlying asset to climb high enough so that it at least covers the cost of the option’s premium.
Key Points
- An ITM call option means the option holder can buy the asset below its current market price
- An ITM put option means the option holder can sell the asset above its current market price
- An option that is ITM does not necessarily mean the trader is making a profit on the trade.
- A call option that is ITM at expiry has a chance to make a profit if the market price is above the strike price
- An investor holding an ITM put option has a chance to earn a profit if the market price is below the strike price
ITM Options in play
Let’s say Mr. Witherblock holds a call option on Bitcoin with a strike price of $30. Bitcoin currently trades at $33 at expiry, meaning the contract is — in the money. The call option allows Mr. Witherblock to sell the Bitcoin for $33, giving him a $3 per Bitcoin difference. Each option contract represents 100 Bitcoin, so the intrinsic value is $3 x 100 = $300.
Let’s say Mr. Witherblock had paid a premium of $3.50 for the call. In this case he would not profit from the trade. Why? Well, he would have paid $350 ($3.50 x 100 = $350) while only gaining $300 on the difference between the strike price and market price. In other words, Mr. Witherblock would lose $50 on the trade. However, the option is still considered ITM because, at expiry, the option will have a value of $3 even though poor Mr. Witherblock is not making any profit.
Now let’s say Bitcoin’s price fell from $33 to $29, that would mean the $30 strike price call is no longer ITM. It would be $1 Out the Money.
It’s important to note that while the strike price is fixed, the price of the underlying asset will fluctuate affecting the extent to which the option is in the money. An ITM option can move to an ATM position or even OTM before its expiration date.
📌Out of the Money
“Out of the money” (OTM) is an expression used to describe an option contract that has no intrinsic value and only contains extrinsic value.
OTM Call Options
A call option is OTM if the current price of the underlying asset is lower than the strike price. If the buyer of the call option exercised their right under the option contract to buy the underlying asset, they would be paying more than its current value.
If the strike price of a call option is $6 and the underlying asset is currently trading at $5, the option is OTM. The lower below $6 the price goes, the more OTM the option is.
OTM Put Options
A put option is OTM if the current price of the underlying asset is higher than the strike price. If the buyer of the put option exercised their right under the option contract to sell the underlying asset they would be receiving less than its current value.
If the strike price of a put option is $5 and the underlying asset is currently trading at $6, the option is OTM. The higher above $5, the more OTM the option is.
Because OTM put and call options can not be exercised for a profit, their intrinsic value is zero
For Example:
Bella wants to buy a call option on $ETH. She buys a call option with a $20 strike price. The option expires in five months and costs $0.50. This gives her the right to buy $ETH at a price of $20 at the expiration date. The total cost of the option is $50. ETH is currently trading at $18.50.
Upon buying the option, the option is OTM because if Bella exercised the option, she would have to pay $20 for $ETH when she can currently buy it at a market price of $18.50. Although this option is OTM, it isn’t worthless yet, as there’s still potential to make a profit if it moves in the money.
If $ETH is trading at $22 at expiry — the option is now ITM. The option gives Bella the right to buy $ETH at $20, while the current market price is $22. The difference between the strike price and the current market price is the intrinsic value, which is $2. In this case, Bella ends up with a net profit of $1.50. She paid $0.50 for the option and that option is now worth $2.
But what if $ETH only reached $20.25 when the option expired? In this case, the option is still ITM, but the Bella actually lost money. She paid $0.50 for the option, but the option only has $0.25 of value now, resulting in a loss of $0.25 ($0.50 — $0.25)
📌At the Money
If an option contract’s strike price is the same as the price of the underlying asset, the option is ATM.
i.e. If the strike price of a call or put option is $60 and the underlying asset is currently trading at $60, the option is ATM.
ATM put and call options can not be exercised for a profit, therefore their intrinsic value is zero.
Conclusion
- An option is ATM when the strike price and market price of the underlying asset are of the same value
- An option is OTM if the strike price is not favorable to the market price
- An OTM call option would have a higher strike price than the market price of the underlying asset. Whereas an OTM put option would have a lower strike price than the market price
- An OTM option means that the option has yet to make money because the underlying assets price hasn’t moved enough to make the option profitable. As a result, OTM options usually have lower premiums than ITM options
- The value of the premium paid for an option depends to a larger extent on how much an option is ITM, ATM, or OTM.
- Many factors can affect the premium of an option including volatility, and the time until the expiration. Higher volatility and a longer time until expiration mean a greater chance that the option could move ITM. As a result, the premium is usually higher.
Thanks for reading!
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