Options Explained: ATM, ITM, and OTM - A Complete Guide

What Are Options?

Financial derivatives, known as options, provide the holder with the right, but not the duty, to purchase or sell an underlying asset at a designated price (called the strike price) on or before a designated date. Two kinds of possibilities exist:

Call Options: Granting the holder the right to purchase the underlying asset, call options

Put Options: Gives the holder the right to sell the underlying asset

Both call and put options adhere to the ideas of ATM, ITM, and OTM, which helps one ascertain their value and probability of profitability.

ATM—At The Money

An option is said to be "at the money" (ATM) when its strike price matches the current market value of the underlying asset.

For Call Options: 

A call option is ATM when the strike price matches the current market price of the underlying asset.

Example: A call option with a strike price of ₹500, for instance, is ATM if a stock is trading at ₹500.

For Put Options:

 It is ATM when the strike price matches the current market price of the underlying asset.

Example: A put option with a strike price of ₹500, for instance, is also ATM if a stock is trading at ₹500.

Significance:

• Usually having the highest time value and most sensitivity to volatility swings, ATM options.
• Traders wishing to hedge or speculate with little inherent value often choose them.

ITM—In The Money

When an option has inherent value—that is, when the strike price is favourable relative to the market price of the underlying asset—that option is "In The Money" (ITM).

For Call Options: 

A call option in call terms is ITM when the strike price falls below the underlying asset's current market price.

Example: For instance, ITM by ₹50 if the stock is trading at ₹550 with a strike price of ₹500. 

For Put Options:

 A put option for Put Options is ITM, whereby the strike price exceeds the underlying asset's current market price.

Example: For instance, ITM by ₹50 if the stock is selling at ₹450 with a strike price of ₹500.

Significance: 

• While more costly than ATM or OTM options, ITM options have inherent value.
• Usually safer and more likely to be profitable are these choices.

OTM—Out of The Money

When an option has no intrinsic value—that is, when the strike price is not advantageous relative to the market price of the underlying asset—that is known as "Out of The Money" (OTM).

For Call Options: 

A call option is OTM when the strike price exceeds the underlying asset's current market price.

Example: For instance, OTM on a call option with a strike price of ₹500 is if the stock is trading at ₹450.

For Put Options:

 A put option is OTM, when the strike price falls below the underlying asset's current market price.

Example: For instance, OTM for a put option with a strike value of ₹500 is the stock trading at ₹550.

Significance: 

• Although OTM options are less expensive, they are riskier since they depend just on the possibility for the price of the underlying asset to move in favour.
• They are usually utilised in speculative deals, where the trader expects notable price volatility, these options.

Understanding ATM, ITM, and OTM is key to forming effective trading strategies:

Forming good trading strategies depends on an awareness of ATM, ITM, and OTM:

• Risk Management: ITM options are less risky and fit for conservative traders; OTM options are more speculative and fit for aggressive methods.
• Leverage: Compared to ITM options, ATM options give good leverage at a reduced cost and balance of risk and reward.
• Profit Potential: While OTM options require the underlying asset to move significantly to provide profit, ITM options offer greater inherent value and are more likely to be lucrative at expiration.

Real-World Example: Making a Decision

Assume a stock of a company is trading at ₹1,000, and you are expecting it to rise to ₹1,300 in one-month time. You have three choices:

• ITM Call Option: Strike price ₹900—it costs more, but you're already in a pretty good spot to make money.
• ATM Call Option: Strike price ₹1,000—it is a moderate amount; not too risky and not too safe.
• OTM Call Option: Strike price ₹1,200—it is cheaper, but then you're betting the stock will make a big move.

By contrast, if the stock were to hit ₹1,300, then all three options could finish in-the-money and positive. However, the ITM option that you have could have a higher upfront cost, while the OTM option could return a higher percentage. Your preference will be dictated by how much risk you want to have and what you think the market is going to do.

Conclusion

In options trading, knowing the difference between ATM, ITM, and OTM options is vital for making informed trading decisions. Each has advantages and drawbacks; traders should pick depending on their trading objectives, risk tolerance, and view of the market. Knowing this terminology will enable you to more confidently negotiate the options market, whether your goals are hedging, speculating, or revenue generating.

To help you maximise your options trading, AlmondzTrade provides sophisticated trading tools and professional advice. Using our knowledge to negotiate the complexity of ATM, ITM, and OTM alternatives, let us help you develop a plan fit for your financial objectives.