One of the basic but critical aspects that any option trader should be familiar with is moneyness. It represents the intrinsic value which affects the option's pricing. In terms of their “moneyness”, option contracts fall into the following categories: “in the money” (ITM), “out of the money” (OTM), and “at the money” (ATM).
In this article we will explain on the importance of moneyness mainly focusing on long options.
- The ability to make a distinction between “out of the money vs in the money options” is crucial in determining the pricing and potential return of options.
- ITM options inherently possess intrinsic value, whereas OTM options do not.
- The strategic choice between ITM and OTM contracts is influenced by various factors, including risk appetite, market perspective, and investment goals.
- The decision to opt for ITM or OTM options can significantly impact a trader's potential yield and risk exposure.
As moneyness is directly connected to intrinsic value (IV), we need to define this fundamental concept first. First, as we know, options are a type of derivatives which can not be held indefinitely. Typically, they have an expiration date which indicates the deadline for the owner to exercise them. And if you were to exercise your option right away, its intrinsic value would tell you how much it is in or out of the money.
For calls, the IV is calculated by deducting the option’s strike price from the base asset’s market value. A call is considered to have a positive intrinsic value only when the base asset's price is above the strike. Otherwise, the IV is zero.
For puts, it’s vice versa. The IV equals the option's strike price minus the market value of the base asset. For puts, the strike should be above the base asset's market value. If the exercise price is below the market value, the IV is zero.
In simpler terms, IV reflects how much in or out of the money an option is at a given point in time. A contract with positive intrinsic value is in the money. That is, it will give the trader an immediate profit if they exercise it right now.
Conversely, an option with zero intrinsic value is out of the money. However, it's important to remember that IV is just one of the factors affecting an option's price. The second one is extrinsic value, which you can learn more about from our guide.
In the Money Options Explained
As we aleady mentioned it, “in the money” (ITM) is a term that signifies an option's positive intrinsic value. Let's break down this term for calls and puts.
For calls, being ITM means that the current market value of the base asset is higher than the option's exercise price. In such a scenario, the holder of a call has the right to buy the base asset at a price lower than its current market value, leading to an immediate potential profit.
Below, there is a graphical representation of the long call moneyness. ATM stands for “at the money”. It means that the strike and the base asset price are the same. Everything that is above the ATM level is considered to be ITM.
On the other hand, for puts to be considered ITM, the market value of the base asset must be lower than the option's strike. This positioning allows the holder of a put to sell the asset at a higher price than its current market value, again leading to a potential immediate gain.
Graphically, a long put option is ITM if it is below the ATM line.
The intrinsic value of ITM options is a critical factor that influences their pricing. Given this inherent value, ITM options usually have higher premiums compared to their out-of-the-money counterparts. This elevated cost is a reflection of their potential profitability and the reduced risk they offer to the holder.
Furthermore, the safety cushion provided by the intrinsic value of ITM options makes them a more conservative choice. This cushion means that the base asset's price can move against the option holder's favor to some extent without resulting in a loss, as long as the option remains ITM.
In the Money (ITM) Example
Consider a scenario where a trader holds a call for Bitcoin with a strike of $50. If the BTC current value escalates to $60, the option is ITM by a margin of $10. This $10 difference represents the immediate profit potential for the trader.
In such scenarios, the trader stands to benefit significantly, especially if they had anticipated this price movement. This example underscores the potential profitability of ITM options and their appeal to traders looking for more secure investment avenues.
Out of the Money Options Explained
Unlike their ITM counterparts, long OTM (“out of the money”) options lack the intrinsic value. That is, they aren't immediately profitable if exercised.
Calls are considered to be OTM when the market value of the base asset is lower than the contract's strike price.The holder of the call option wouldn't benefit from exercising the option, as they would be committing to buying the asset at a price higher than its current market value.
In the case of puts, they are considered OTM when the market value of the base asset is higher than the option's exrcise price. Here, the holder of a put wouldn't gain from exercising the option, since they would be selling the asset at a price lower than its prevailing market rate.
As the OTM options don’t have any intrinsic value, they are much cheaper than ITM options. For that reason, out of the money contracts may be attractive for traders with limited capital. These options are primarily purchased with the hope that the market will move favorably and OTMs will transition into ITMs before expiration.
However, the very nature of OTMs pricing means they carry a higher risk. The entire premium paid for an OTM option can be lost if the option remains OTM until expiration. However, the potential for substantial returns exists. If the market does move in the anticipated direction, the percentage returns on OTM options can be significant, often exceeding those of ITM options.
Out of the Money (OTM) Example
Using the earlier stock illustration, if a trader possesses call contracts with an exercise price of $50, but the stock's market value is currently at $40, the option is OTM. Here, the option has no intrinsic value, implying that immediate exercise wouldn't yield a profit.
In such cases, traders need to be strategic about their next steps, considering factors like time value and market volatility. This example highlights the speculative nature of OTM options and the importance of market timing.
In the Money, Out of the Money: What's the Difference?
The primary distinction between ITM and OTM options revolves around intrinsic value. ITMs, with their inherent profitability potential, typically command higher premiums. On the other hand, OTMs, while more affordable, are priced based on their potential to transition to ITM status in the future.
This difference also impacts the premium of these options. ITM options, with their inherent profitability potential, typically have higher premiums.
The cost of options, often termed as their premium, is influenced by several factors, including intrinsic value, time value, and market dynamics. ITM options, due to their intrinsic value, generally demand higher premiums. This elevated cost mirrors their potential profitability and reduced risk profile. OTM options, in contrast, are priced lower, reflecting their speculative nature.
The premium, which traders pay to purchase an option, is a crucial component in derivatives trading. It represents the price of the rights the option grants. While ITM options come with a higher upfront cost, they offer a greater probability of yielding a profit. On the other hand, OTM options, with their reduced cost and potential for substantial returns, appeal to traders with a speculative market outlook.
It's essential for traders to understand that while the premium for ITM options might be higher, it's often justified by the intrinsic value they possess. Conversely, the lower premium for OTM options is reflective of their speculative nature and the higher risk associated with them.
Risk for Buyers and Sellers
Every financial instrument carries inherent risks, and options are no exception. The risk dynamics for buyers and sellers of options vary based on whether the option is ITM or OTM.
For buyers, ITM options present a higher probability of profit but at an elevated cost. OTM options, while more affordable, are inherently speculative and come with the risk of losing the entire premium paid.
Sellers of ITM options face the potential risk of the option being exercised, leading to potential losses, especially if they don't own the base asset. Conversely, OTM option sellers risk the option transitioning to ITM status, but they might benefit from the option expiring worthless, allowing them to retain the premium received.
At its core, time value reflects the potential future value of an option, encompassing the anticipation and uncertainty surrounding the base asset's price movement before the option's expiration.
To break it down, an option's premium consists of two main components: intrinsic value and time value. While intrinsic value relates to the immediate profitability of an option based on the current market value of the base asset, time value is more abstract. It captures the potential for the option to become profitable or even more profitable in the future. Essentially, it's the price traders are willing to pay for the possibility that market conditions might change in their favor.
However, time is a diminishing asset in the world of options. As the expiry date of an option draws closer, the uncertainty and potential for significant price movements decrease.
This reduction in potential future profitability is reflected in the eroding time value, a process commonly referred to as “time decay” or “theta decay".
For OTM options, time value plays an even more crucial role. Since they lack intrinsic value, their entire premium is often made up of time value. This makes them particularly sensitive to the effects of time decay. If the market doesn't move in the anticipated direction quickly enough, the rapidly eroding time value can lead to substantial losses for the holder of the option.
Conversely, in-the-money options, which possess intrinsic value, are less susceptible to the effects of time decay. Their premium consists of both intrinsic value and time value, providing a buffer against the eroding effects of time.
It's also worth noting that other factors, such as changes in implied volatility, can influence time value. A surge in implied volatility can increase an option's time value, even if it's nearing expiration, while a drop can reduce it.
The main takeout for the time value concept is that it represents the potential future profitability of an option, diminishing as the option nears its expiry date. This concept is especially crucial for out-of-the-money options, where the entire premium often hinges on time value, making them highly sensitive to time decay.
As already mentioned, at-the-money (ATM) options have a strike price nearly identical to the base asset's current market price. They don't possess intrinsic value and are primarily influenced by time value and implied volatility.
So, is there any advantage of purchasing ATM options? ATM options provide traders with a middle-ground choice that carries its own set of risks and rewards. They serve as a strategic option for traders who anticipate minimal price movement in the base asset.
Should I Buy ITM or OTM Options?
The decision to procure ITM or OTM options is influenced by various factors, including risk appetite, market perspective, and investment objectives. ITM options, with their intrinsic value, are often favored by conservative traders who seek a higher probability of profit. OTM options, with their reduced cost and potential for substantial returns, appeal to traders with a speculative market outlook.
It's crucial for traders to assess their financial goals, risk tolerance, and market expectations before making a choice. Each type of option offers its own set of advantages and challenges, and understanding these can help traders make more informed decisions.
The Bottom Line
In the multifaceted world of options trading, understanding the nuances of ITM and OTM options is imperative. They serve as the cornerstone upon which informed trading decisions are anchored. Whether one is a seasoned trader or a novice, grasping the intricacies of these options is crucial for financial success. As markets evolve, with assets like Bitcoin and other cryptocurrency becoming increasingly relevant, the importance of making informed decisions in derivative trading cannot be overstated.
What Happens When Options Expire in the Money?
Options that expire ITM inherently possess intrinsic value, making them valuable. Typically, these options are automatically exercised, leading to the purchase or sale of the base asset. However, traders can also opt to sell these options before expiration to capture their value. It's essential for option holders to be aware of the implications of automatic exercise, especially if they don't intend to hold the base asset.
What Happens When Options Expire Out of the Money?
OTM options that reach expiration are devoid of intrinsic value and thus become worthless. They are not exercised, and the premium paid for the option is forfeited. For traders, it's a reminder of the speculative nature of OTM contracts and the importance of active portfolio management. It's crucial to understand that while the potential for high returns exists, the risk of total loss of the initial investment is also present.
Why Should You Buy In-The-Money Options?
Purchasing ITM options can be a strategic move for traders for several reasons:
- Higher Probability of Profit: ITM options inherently possess intrinsic value, indicating a higher likelihood of profitability.
- Reduced Time Decay: ITM options are less influenced by time decay compared to OTM options.
- Strategic Flexibility: Traders can opt to exercise ITM options before expiration or sell them to capture their value.
- Hedging Potential: ITM options can serve as effective hedging instruments against adverse market movements.
While ITM options offer several advantages, they come at a higher premium. Traders must weigh the benefits against the cost to determine if ITM options align with their trading strategy and overall financial objectives.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.