Derivatives are financial instruments whose value depends on the underlying assets. Futures and options are the two most widely traded derivatives. In the world of future and options trading, the terms ATM, OTM, and ITM are used quite often. You can make a better sale if you understand these terms. This blog will help you understand these terms and how they are used in options trading.
Understanding ATM, ITM and OTM in Option Trading
According to the term “Moneyness”, options contracts may be defined into three categories. Option moneyness helps a trader assess whether an option contract will yield gains if exercised swiftly. You should know the three monetary terms in options trading as mentioned below.
- At The Money (ATM)
- Out of The Money (OTM)
- In The Money (ITM)
At The Money (ATM)
An option contract with an At The Money (ATM) strike price that is near to the spot price is known as an ATM option. It is regarded as an ATM option even in an instance where the strike price and the spot price are equal.
For instance, if the closest option strike price is Rs. 7,150 and the market price of a currency pair with Rs.is Rs 7,200, the intrinsic value would be Rs 7,200 – Rs 7,150 = Rs 50. It will therefore be an ATM option. ATM options imply a moderate premium relative to OTM and ITM. Whereas, the probability of earning expected gains is reasonable because they have only time values with no intrinsic value.
Out The Money (OTM)
If the option contract does not contain an intrinsic value, it will be called an Out The Money Option. The spot price is less than the strike price for a call option in OTM. The strike price of the put option in OTM is lower than the spot rate. If the spot price of Rs. 7,200 and the strike price is Rs. 8,300, the intrinsic value is 7,200 – Rs 7,300= -100. A negative intrinsic value is zeroed out. The OTM call option is a contract of options that has zero interpretable value.
Compared to ITM, OTM options are less expensive because the premium is based on a period. You can choose OTM if you expect a positive currency price movement because it involves fewer upfront payments.
In The Money (ITM)
The term “in the money” (ITM) refers to an option contract that has intrinsic value. There would be a higher spot price for the call option in ITM compared to the strike price. The spot price would be lower than the strike price for a put option in ITM.
The intrinsic value would be Rs. 7,200 and the option strike is Rs. 6,900. So, the intrinsic value would be Rs. 7,200 – Rs. 6,900 = Rs. 300. This option contract is considered to be an ITM call option because of its intrinsic value. On average, the premiums for ITM options are higher than those of OTM and ATM. However, because the premium is based on intrinsic and time value, there is a high likelihood of receiving the expected profit.
Time Value in ATM, OTM and ITM Options
If you have spent the time and effort to understand the nuances of foreign exchange options trading, then you may make profitable trades. To trade currency pairs, the first step is to know how to select ATM, ITM, and OTM. The time value of the options must be taken into account when choosing any of these. The time value, also known as the intrinsic value, is the value of the underlying asset over and above the intrinsic value. It has a time value throughout the option contract up to the expiry date.
As the contract comes to an end, this value will decrease slowly. The option that expires three months later is more expensive and has a longer period than that of the current month. This is because the chances of a trade going your way increase when the contract has a longer period to expire. Therefore, before selecting a particular type consider the remaining time for an option contract.
Conclusion
In option contracts based on intrinsic value, ATM, OTM, and ITM are three broad categories of money worthiness. Many terms can be confusing to understand in the online trading of financial instruments and derivatives. However, to understand the concepts thoroughly, traders have to invest time. They may be very useful for becoming a more efficient trader. To start futures and options trading you can go ahead with easy-to-use apps like Kotak Securities. You may also understand the difference between futures and options. The renowned firm offers all the essential resources that help investors make informed decisions.
