The Basics: Strike Price and Market Price
Let’s review some foundational concepts:
- Strike Price:The price at which you have the contractual right to buy (for calls) or sell(for puts) the underlying asset
- Market Price:The current trading price of the underlying asset
- Intrinsic Value:The amount by which an option is in-the-money – i.e immediate theoretical value the option would have if exercised at that moment
- For calls:Market Price minus Strike Price
- For puts:Strike Price minus Market Price
- Exercise: To exercise an option means to make use of the right granted by the contract -i.e., to buy (for calls) or sell (for puts) the underlying asset at the strike price, if the option is in-the money and within the contract terms.
What Are In-the-Money (ITM) Options?
An option is considered "in-the-money" when the current market price of the underlying asset is favourable relative to the option’s strike price – meaning that exercising the option would have positive intrinsic value, before considering costs such as the premium paid.exercising it would result in a profit based solely on the difference between the strike price and the current market price (ignoring the premium paid). Let’s look at some examples.
Important: These examples are for illustrative purposes only. They do not constitute investment advice or a recommendation to trade. Options are complex products and are not suitable for all investors. Capital is at risk.
For Call Options:
Condition: MarketPrice > Strike Price
A call option is considered in-the-money (ITM) when the market price of the underlying asset is above the option’s strike price.
Example: You hold a Tesla (TSLA) call option with a strike price of £700. If Tesla is currently trading at £750, your option is in-the-money by £50 per share. This means you have the right to buy Tesla shares at £700 each, even though they are trading at £750 in the market.
Explanation: Call options give the holder the right to buy at the strike price. When the market price is higher than the strike price, the option has positive intrinsic value, as exercising it would allow purchase of shares below the current market price.
However, exercising the option is a choice and may depend on factors such as costs, timing, and individual circumstances.
For Put Options:
Condition: MarketPrice < Strike Price
A put option is considered in-the-money (ITM) when the market price of the underlying asset is below the option’s strike price.
Example: You hold an Amazon (AMZN) put option with a strike price of £120. If Amazon is currently trading at £100, your option is in-the-money by £20 per share. This means you have the right to sell Amazon shares at £120 each, even though they are trading at £100 in the market.
Explanation: Put options give the holder the right to sell the underlying shares at the strike price. When the market price is lower than the strike price, the option has positive intrinsic value because exercising the option would allow selling shares above the current market price.
However, exercising the option is a choice and may depend on factors such as costs, timing, and individual circumstances.
The Significance of Intrinsic Value
ITM options have intrinsic value, which is calculated as the difference between the market price and strike price, where this difference is positive.
Example: If you hold a Microsoft (MSFT) call option with a strike price of £300 and the stock is trading at £320, your option has an intrinsic value of £20 per share. If the option is currently trading at £25, then £20 represents intrinsic value, and the remaining £5 represent extrinsic value (also know as time value).
Price Dynamics and Trading Considerations
Premium Costs
ITM options typically require a higher initial investment but may have a higher probability of being profitable upon exercise, although no profit is guaranteed.
Example: An NVIDIA (NVDA) call option with a strike price of £700 when NVIDIA is trading at£750 (ITM) might cost £60, while a call option with a strike price of £800 (OTM) might only cost £15.
Explanation: The ITM option’s price includes £50 of intrinsic value plus £10 of extrinsic value (time value), whereas the OTM option's price consists entirely of extrinsic value (time value) based on the possibility of the stock rising above£800 before expiration.
Risk and Reward Profiles
ITM options offer higher price sensitivity to the underlying asset's movement (delta, which we will introduce you to later!) and higher probability of profitable exercise, but require larger capital outlay and offer lower percentage returns.
Example: If you invest £1,000 in ITM SPY call options and the market moves favourably by 5%,your options might gain 20-30% in value. In contrast, investing £1,000 in OTM SPY call options with the same market movement might yield a 50-100% gain - or potentially a complete loss if the market doesn't move enough to bring them ITM by expiration.
Strategic Applications
When to Consider ITM Options
- When seeking more conservative options strategies
- ITM options tend to behave more like the underlying asset, potentially providing more predictable price movement.
- They may be less affected by time decay (theta) in the short term, but this can vary depending on market conditions.
- When using options for income generation
- Covered call writers might choose slightly ITM options when they're willing to sell their shares at the strike price while collecting premium. However, this strategy involves risks, including the possibility of shares being called away.
At-the-Money (ATM) Options: The Middle Ground
Important: This example is for illustrative purposes only. Options are complex products and not suitable for all investors. Capital is at risk.
For completeness, it's worth mentioning"at-the-money" (ATM) options, where the strike price is approximately equal to the current market price. Let’s look at an example.
Example: IfMicrosoft is trading at exactly £300 and you hold a Microsoft call or put option with a £300 strike price, your option is considered at-the-money.
Explanation:ATM options represent the transition point between in-the-money (ITM) and out-the-money(OTM). They have no intrinsic value because the strike price equals the market price.
Recap
An option is considered in-the-money when exercising it would result in a profit based solely on the difference between the strike price and the current market price (ignoring the premium paid).
In-the-money (ITM) options typically cost more because they include intrinsic value, and may be more likely to offer a profit if exercised under favourable market conditions, although no profit is guaranteed.They may be more appropriate for conservative strategies or income-generating approaches. For ITM calls, intrinsic value equals the market price minus the strike price; for ITM puts, it equals the strike price minus the market price.
But remember: options trading isn’t for everyone. It's important to thoroughly understand the mechanics and risks before trading options.