The terms ATM, OTM, and ITM appear frequently in online F&O trading. Understanding these terms can help you trade better. If you are wondering what these terms mean, you’re in the right place.
This blog will help you understand what is ATM/OTM/ITM in options trading. Before jumping into these terms, let’s talk about core terminologies that will make it easier to unwrap ATM/OTM/ITM options.
Basic Options Terms You Must Know
- Strike Price: The strike price is the set or predetermined price at which the options contract will have to be exercised.
- Spot Price: The spot price is the latest price at which the options contract is being traded.
- Intrinsic Value: The intrinsic value is the value expected by the buyer of an options contract given that he/she exercises the contract on a particular day. Intrinsic value is calculated by deducting the current price (spot price) from the set price of the currency (strike price) for the call option and vice versa for the put option. The intrinsic value of an option will always be positive or zero and it can not acquire a negative value.
Now that these basic terms are clear, let’s get into the concept of ATM ITM OTM.
What is ATM/OTM/ITM in Options Trading?
Options contracts can be classified into three categories based on the term “moneyness”. Option moneyness helps a trader decide whether an option contract will earn gains if exercised immediately. These are the three moneyness terms you should know:
- At The Money (ATM)
- Out of The Money (OTM)
- In The Money (ITM)
The intrinsic value determines the three different kinds of option contracts. Here we explain each classification to resolve your query on what is ATM OTM ITM in options.
1. At The Money (ATM)
If you are wondering what is ATM, here is your answer. At The Money (ATM) option is an option contract whose strike price is closest to the spot price. Even if the strike price is the same as the spot price, it is considered an ATM option.
For example, if the spot price of a currency pair with INR is Rs 8,200 and the closest strike price of an option is Rs 8150, the intrinsic value would be Rs 8,200 – Rs 8,150= Rs 50. Thus, it will be an ATM option.
ATM options involve paying a moderate premium in comparison to OTM and ITM, whereas the probability of receiving the expected gains is fair since it consists only of time value and not intrinsic value.
2. Out of The Money (OTM)
If the option contract has a zero intrinsic value, it will be termed an Out-Of-The-Money (OTM) option. A call option in OTM has a spot price lower than the strike price. A put option in OTM has a strike price lower than the spot price.
Considering the spot price of Rs 8,200, if there is a strike of Rs 8,300, the intrinsic value would be Rs 8,200 -Rs 8,300= -100. A negative intrinsic value is considered zero. An options contract with zero intrinsic value is an OTM call option.
OTM options are less costly when compared to ITM, as the premium consists of only time value. If you expect a positive price movement on a currency, you can choose OTM as it involves less up-front payment.
3. In The Money (ITM)
If the option contract has an intrinsic value, it is termed In The Money (ITM). A call option in ITM would have a higher spot price than the strike price. A put option in ITM would have a spot price lower than the strike price.
If the spot price is Rs 8,200 and there is an option strike for Rs 7900, the intrinsic value would be Rs 8,200 – Rs 7,900= Rs 300. Since it has an intrinsic value, this option contract will be regarded as an ITM call option.
The premium for ITM options is typically more than that of OTM and ATM. However, the probability of receiving the expected gains is high as the premium consists of intrinsic value and time value.
Time Value in ATM, OTM, ITM Options
If you have taken the time and effort to understand the nuances of forex options trading, then the answer is yes to is forex trading profitable. The first step is to know how to select ATM ITM OTM while trading currency pairs.
In selecting any of these, you need to consider the time value of the options. Time value, also called ‘extrinsic value’ is the value of the underlying asset over and above the intrinsic value. During the entire lifecycle of the option contract until the expiration date, it holds a ‘time value’.
This value decreases gradually as the contract nears expiry. The option that expires three months later will be more expensive and have more time value when compared to an option that expires in the current month.
The reason is that when a contract has more time left in expiry, the chances of the trade going in your favor increase. Thus, consider the time value left on the option contract before choosing a specific type.
Options Greeks & ATM/ITM/OTM Options
Options Greeks are mathematical values used to determine the value and subsequent risk attached to each contract. The most popular Greeks in options include:
Each Greek plays a crucial role in how ATM, ITM, and OTM options behave. That’s why you need to understand them in greater detail to trade options better.
If you see Delta on an Options Chain or in a section about Greeks, you can safely assume that it represents the sensitivity of an option’s price to changes in the underlying asset’s price.
Gamma measures the rate of change of the preceding Greek Delta. Check out the table below to know what each Gamma value represents.
By checking Theta, you’ll understand the time decay of every option contract. Time decay simply means how much an option’s value decreases with each passing day toward expiry.
Vega is a Greek that measures an option’s sensitivity to changes in implied volatility.
Understanding the interplay between Greeks and ATM/ITM/OTM options can help you determine which options type fits your trading goals and risk appetite.
ATM, OTM, and ITM are three broad classifications of moneyness in option contracts based on intrinsic value. Online F&O trading is packed with terms that may be tough to understand.
However, traders must invest time in understanding the terminologies involved. They can be useful in becoming a better trader, especially when it comes to ATM/OTM/ITM options. For more useful information, check out these blogs: