In-The-Money (ITM)
In-The-Money (ITM): Understanding the Concept in Options Trading
The term In-The-Money (ITM) is used in options trading to describe a situation where an option has intrinsic value. An option is considered "in-the-money" when it would result in a profit if exercised immediately. ITM is an important concept for both call and put options, and understanding it is key to making informed decisions when trading options.
In options trading, there are three primary states an option can be in: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). Each state represents a different level of potential profitability for the option holder.
In-The-Money (ITM) in Call Options
A call option gives the holder the right, but not the obligation, to buy an underlying asset (such as a stock) at a specified price (the strike price) before a certain expiration date.
A call option is in-the-money (ITM) when the current market price of the underlying asset is higher than the option’s strike price. In this situation, the holder could exercise the option and buy the asset at the lower strike price, immediately realizing a profit if they were to sell the asset at the higher market price.
For example:
If you have a call option with a strike price of $50, and the current market price of the stock is $60, the option is in-the-money. You could buy the stock at $50 and sell it at $60, making a profit of $10 per share (ignoring fees or commissions). The intrinsic value of the call option is $10.
The deeper in-the-money a call option is, the higher the intrinsic value, and thus the greater the profit potential if the option were exercised.
In-The-Money (ITM) in Put Options
A put option gives the holder the right to sell the underlying asset at the strike price before the option’s expiration date.
A put option is in-the-money (ITM) when the current market price of the underlying asset is lower than the option’s strike price. In this case, the option holder can exercise the option to sell the asset at the higher strike price, making a profit by purchasing the asset at the lower market price and selling it at the higher strike price.
For example:
If you have a put option with a strike price of $70, and the current market price of the stock is $60, the option is in-the-money. You could buy the stock at $60 in the open market and sell it for $70 using the option, realizing a profit of $10 per share (again, ignoring any transaction fees). The intrinsic value of the put option is $10.
As with call options, the deeper in-the-money a put option is, the greater the intrinsic value and the higher the potential profit for the holder.
The Difference Between Intrinsic Value and Time Value
While an option’s market price (premium) consists of both intrinsic value and time value, being in-the-money simply refers to the option having intrinsic value.
Intrinsic Value: This is the amount by which an option is in-the-money. It represents the immediate profit that could be made if the option were exercised right now. For a call option, this is the amount by which the market price exceeds the strike price, and for a put option, it’s the amount by which the strike price exceeds the market price.
Time Value: This is the extra value an option has due to the time left until its expiration. The more time remaining, the more time value an option typically has. As the expiration date nears, time value decreases (this is known as time decay).
For an in-the-money option, the price you pay for it (premium) is made up of both the intrinsic value (the portion that is ITM) and time value.
Factors That Affect In-The-Money (ITM) Options
Several factors affect whether an option is in-the-money, as well as how deep in-the-money it is:
Underlying Asset Price: The most important factor is the current price of the underlying asset compared to the option’s strike price. For call options, the higher the market price, the deeper the option is in-the-money. For put options, the lower the market price, the deeper the option is in-the-money.
Strike Price: The strike price is the agreed-upon price at which the option holder can buy or sell the underlying asset. When the strike price is below the market price for a call option or above the market price for a put option, the option is in-the-money.
Time Until Expiration: The longer the time until the option’s expiration, the more likely it is to be able to move further into-the-money. However, options lose time value as expiration approaches, which can affect their market price even if they remain in-the-money.
Volatility: The volatility of the underlying asset can also influence whether an option is in-the-money. Volatility increases the chances of the asset price moving further in the holder’s favor before expiration, potentially increasing the option’s intrinsic value.
Interest Rates: For certain options, such as those on interest rate-sensitive assets, changes in interest rates can impact the price of the underlying asset and thus the in-the-money status of the option.
Importance of In-The-Money (ITM) Options
Understanding whether an option is in-the-money is essential for options traders because it directly impacts their potential profit. Here are some key reasons why ITM options are significant:
Profitability: If you hold an ITM option, it has intrinsic value, meaning you could exercise the option for an immediate profit (if it’s a call or put with intrinsic value). For instance, a call option with an exercise price of $50 and a market price of $60 has $10 of intrinsic value.
Liquidity: ITM options tend to have better liquidity than out-of-the-money (OTM) options, meaning they are easier to buy and sell on the market. This is because they have a higher probability of being exercised for a profit.
Exercise or Sell: With ITM options, you can choose to either exercise the option or sell it on the market. If you believe the option’s intrinsic value will continue to increase before expiration, you might choose to sell it. Alternatively, you might exercise it for immediate profit.
Cost of ITM Options: Since in-the-money options have intrinsic value, they generally cost more (in terms of premium) than out-of-the-money options. Traders need to be mindful of the cost of the premium relative to the potential for further profits before deciding whether to purchase or sell ITM options.
In-The-Money (ITM) vs. Out-of-The-Money (OTM) vs. At-the-Money (ATM)
To better understand ITM, it's helpful to compare it with the other two primary states of an option:
Out-of-the-Money (OTM): An option is out-of-the-money if it has no intrinsic value. For a call option, this occurs when the strike price is higher than the current market price of the underlying asset. For a put option, it’s when the strike price is lower than the current market price.
At-the-Money (ATM): An option is at-the-money if its strike price is the same as the current market price of the underlying asset. While it has no intrinsic value, it still has time value.
Conclusion
In-the-money (ITM) options are those that have intrinsic value, meaning they would generate a profit if exercised immediately. For call options, this means the market price is higher than the strike price, and for put options, it means the strike price is higher than the market price. Understanding the concept of ITM is crucial for options traders, as it impacts the potential profitability, cost, and strategy for executing options trades. By evaluating whether an option is in-the-money, at-the-money, or out-of-the-money, traders can make more informed decisions on whether to exercise, sell, or hold their options.