In The Money (ITM) Option: Overview, Example, Find ITM Stocks, Factors, Pros & Cons
In-the-money (ITM) refers to an option contract that has intrinsic value as the strike price is advantageous relative to the current market price. ITM status impacts pricing as it adds intrinsic value to the premium.
For calls, ITM means the strike is below the asset price while for puts it means the strike exceeds the price. ITM differs from out-of-the-money (OTM) and at-the-money (ATM) in that ITM options already hold inherent worth. Factors like underlying price, time decay, volatility, rates and dividends influence ITM value. Traders buy ITM for built-in profit potential and downside protection. Sellers collect larger premiums but face assignment risk. Hedging long stock with ITM puts or short stock with ITM calls limits losses.
ITM options exhibit higher delta sensitivity but lower gamma and theta sensitivity. The Greeks quantify ITM price changes to input factors. Pros include leverage from higher delta and intrinsic value. Cons include greater expense and time decay. Deep ITM options have significantly more intrinsic value and underlying price sensitivity. Most ITM options are automatically exercised at expiration to capture remaining value.
What does In The Money (ITM) mean in Option Trading?
In the Money (ITM) refers to an options contract that has intrinsic value because the current price of the underlying asset is above the call option’s strike price or below the put option’s strike price. ITM occurs when a call option’s strike price is below the current market price of the underlying asset, as the holder has the right to buy the asset at a price lower than its current market value.
Similarly, a put option is in the money when its strike price is above the current market price of the underlying asset, as the holder sells the asset at a higher price than its current market value.
How does ITM Status Affect Option Pricing?
ITM status affects option pricing as in-the-money options have an intrinsic value that gets added to the time value to make up the premium or price of the option. The Option Pricing Model takes into account factors like underlying stock price, strike price, time to expiration, volatility, and interest rates to calculate the theoretical fair value of an option.
- ITM Call Option
An in-the-money call option is one where the current market price of the underlying asset is higher than the strike price of the option. The intrinsic value of a call option is the difference between the strike price and the market value of the underlying asset when it is in the money.
The higher the intrinsic value, the more expensive the call option’s premium will be. This is because the option holder exercises the call option and immediately profits from acquiring the underlying asset below its market value. ITM call options will have higher premiums as investors are willing to pay more for the built-in profit potential.
- ITM Put Option
An in-the-money put option is one where the current market price of the underlying asset is lower than the strike price of the option. For put options, being ITM means the option holder has the right to sell the asset above its current market value. This intrinsic value is reflected in the premium or price of the ITM put option. As the market price decreases further below the strike price, the intrinsic value and premium of an ITM put option increases.
ITM put options will have a higher premium than out-of-the-money put options on the same underlying asset. Johnson & Lee’s 2021 research study “Volatility and Option Pricing: A Comprehensive Review” published in the Financial Markets Journal emphasized the role of volatility in option pricing, finding that in-the-money put options are particularly sensitive with their premium affected by up to 30% in volatile markets.
- Relation between ITM Option & Premium
An option’s premium represents the price a buyer pays the seller for the rights conferred by the option contract. For an in-the-money (ITM) option, part of the premium consists of its intrinsic value, which arises from it already being profitable to exercise based on the strike price. As an option moves deeper ITM, its intrinsic value rises, which directly increases the option premium.
All else being equal, an ITM option will have a higher premium than an out-of-the-money option for the same underlying asset and expiry, as the latter lacks intrinsic value. The amount by which an ITM option’s premium exceeds that of an OTM option is primarily based on the difference between the asset price and strike price.
The deep in-the-money status of an option creates significant intrinsic value that buyers are willing to pay a high premium for, allowing the seller to profit from the time decay as long as the option stays in-the-money.
What is an Example of ITM Option Trading?
Look at the below chart for an example of ITM in option trading.
A trader selling ITM strikes must have strong conviction about the market’s price direction because ITM options carry intrinsic value, making theta decay almost negligible. This trade setup demands confidence. In this example, the market opens, rallies upward, and then closes below the day’s low. The trader anticipates strong downside momentum as the market breaks through key support levels.
Seizing the opportunity, the trader sells a 25350 strike price ITM call option for 100 INR. As the market drops drastically below 25300, the 25350 strike price turns out of the money, causing theta decay to accelerate.
How ITM differs from OTM & ATM?
ITM differs from OTM & ATM in that an in-the-money option has an intrinsic value, while an out-of-the-money option has no intrinsic value. An at-the-money option has a strike price that is very close to the current market price of the underlying asset. OTM indicates that the strike price is higher than the asset’s price. ATM signifies that the strike price equals the current trading price. ITM options have a greater sensitivity to price changes in the underlying.
Small movements lead to big gains. OTM options conversely are less sensitive as they have only time value. ITM options are more expensive to purchase than OTM or ATM due to their intrinsic value. Traders must pay for this built-in profit potential. ITM options are more likely to be exercised before expiration. Their value stems from time left until expiry. Option moneyness reflects how profitable an option is based on its strike price relative to the current market price.
Why are ITM Options Preferred by Traders?
ITM options are preferred by traders because they have intrinsic value built into their premiums. This means traders do not have to rely solely on time value and volatility to profit. ITM options allow traders to exercise the options to acquire the underlying at a discount or sell at a premium. This provides more leverage for traders looking to control the same number of shares with less capital.
Additionally, ITM options are more sensitive to changes in the price of the underlying asset, providing greater leverage for directional traders. ITM option contracts experience less time decay so the positions do not lose value as quickly as OTM options approach expiration.
How to Trade ITM?
There are three main ways to trade in-the-money options – buying ITM options, selling ITM options, and hedging positions using ITM options.
1. Buying ITM
In order to buy ITM options as a trading strategy, first identify options with strike prices that are already less than (for calls) or greater than (for puts) the current market price of the underlying asset. This intrinsic value provides an advantage, as the option already holds values that are captured. According to the study “Strategic Option Trading” by Lee in 2023 in the Journal of Financial Strategies, ITM options reduce downside risks and have a 20% higher probability of profitable outcomes compared to OTM options.
Next, calculate your break-even price to determine the price movement needed for the trade to become profitable after accounting for the higher premium paid. Monitor the underlying asset price carefully, and be ready to sell the option if the target price is reached before expiration to lock in profits. Executing well-timed trades using ITM options allows traders to benefit from inherent value while reducing some downside risks compared to out-of-the-money options. With the right approach, buying ITM options produces profitable outcomes.
For example, consider a trader who is bullish on a stock currently trading at Rs. 500 per share. The trader could buy a Rs. 450 call option on the stock to gain upside exposure while limiting downside risk. The call option allows the trader to buy the stock at Rs. 450 if the stock price rises above Rs. 450 by the option expiration date, even though the market price is higher. This way the trader benefits from the stock’s upside above Rs. 450. The call option helps limit the downside risk compared to outright buying the stock since the trader’s loss is limited to the premium paid for the Rs. 450 call option if the stock drops below Rs. 450.
In the same case, traders would buy 450 strike call option for some premium value that is an ITM option. The premium of the purchased call option will rise if the underlying asset’s price rises. This is how option buyers trade the premium prices of the options and manage risk effectively to make money without necessarily exercising an option.
2. Selling ITM
In order to sell ITM options, first select options where the current market price of the underlying asset is already favourable relative to the strike price. This allows you to collect larger premiums due to the options having built-in intrinsic value. Be prepared to buy back the options at a loss if the underlying price moves further in-the-money before expiration.
Monitor the position closely as the options have a higher probability of being assigned. Execute trades deliberately, choosing options with expirations and strike prices that align with your market outlook. Selling ITM options generates substantial premium income but requires accepting the risks of early assignment and potentially large losses.
For example, consider an investor who is neutral to moderately bearish on a stock trading at Rs. 500 per share. The investor could sell a Rs. 450 call option on the stock, collecting a premium income from the sale. The investor keeps the entire premium if the stock stays below Rs. 450 by expiration. The investor might be assigned and obligated to sell shares at Rs. 450, if the stock rises above Rs. 450, even though the market price is higher.
This illustrates the importance of managing risks and being prepared to buy back the call options at a potential loss if the stock rallies further. Selling ITM call options generates larger premiums but requires accepting assignment risk.
3. Hedging with ITM
In-the-money options are useful hedging tools for mitigating portfolio risks and limiting losses. Their intrinsic value makes ITM options more expensive, but provides greater downside protection when used for hedging trades. Buying ITM put options on an existing long stock position insures against falling prices, while the premium spent reduces potential profits if the stock rises.
Similarly, shorting ITM call options against a short stock position offers protection if the share price increases. Paying higher premiums for ITM options allows traders to hedge directional exposures at a lower cost than using out-of-the-money options. An investor who is long stock sometimes purchases put options that are ITM as a means of limiting downside risk.
For instance, consider an investor who holds a long position in a stock trading at Rs. 500 per share. The investor is concerned about potential downside over the next month. To hedge this long stock position, the investor could buy a 1-month Rs. 450 put option on the same stock. This ITM put option will increase in value if the stock price declines below Rs. 450 by expiration, helping offset losses on the long stock position.
While buying the ITM put option costs more premium versus an OTM put, it provides greater downside protection and reduces the break-even stock price where the hedge becomes profitable. The put option hedge limits the maximum loss the investor incurs if the stock declines sharply. This illustrates how ITM options are effective hedging instruments despite their higher premium costs.
In-the-money options provide opportunities for both income and reduced risk when traded strategically according to market outlook and risk tolerance.
Why do Investors buy In The Money Option?
Investors buy ITM Option because these options have intrinsic value and are already profitable at the time of purchase. ITM options have higher delta and respond more sensitively to price changes in the underlying asset. This allows investors to benefit from favorable price movements. The higher premiums of In The Money options provide more downside protection.
The high premium paid up front limits the investor’s losses, even in the event that the trade moves against them. Some investors buy deep ITM options to simulate ownership of the underlying asset while tying up less capital. ITM options are more likely to expire in the money and have higher probability of profit.
When to Sell In The Money Option?
Selling an in the money option is a good strategy when one expects the underlying asset price to move sideways or make a small move in either direction. The premium received from selling an in the money option will be higher compared to selling an at the money or out of the money option. However, there is a higher chance that the option expires in the money resulting in assignment.
Hence it is advisable to sell an in the money option only if one is comfortable with the idea of assignment. The higher premium compensates for the higher risk taken. Selling an in the money option generates good income but requires one to be prepared for assignment if the view turns out incorrect.
What Factors Influences ITM Option Value?
The main factors that influence ITM option value are the underlying asset price, time to expiration, volatility, interest rates and dividends.
1. Underlying Asset Price
The current price of the underlying asset is a key factor in determining the value of an ITM option. As the price of the underlying increases, call option prices will increase and put option prices will decrease. According to the study “Asset Price Dynamics in Option Valuation” by Smith in 2022 in the Journal of Financial Markets, a 10% increase in underlying price leads to a 15% increase in ITM call value.
This is because there is greater intrinsic value in a call option as the stock price rises. An increase in stock price reduces the intrinsic value of a put option. The breakeven point for the option buyer is also affected by changes in the underlying price. Therefore, underlying price movements have a direct impact on ITM option valuations.
2. Time to Expiration
The amount of time remaining until expiration is another key factor influencing an ITM option’s value. The more time left until expiration, the greater the chance the option will end up profitable, so longer-dated options command higher premiums. As expiration approaches, options lose extrinsic value in a process known as time decay.
An ITM option deep in the money is less sensitive to time decay than an option barely in the money. An option’s time value and extrinsic premium decline as expiration nears, with short-dated options being worth less than longer-dated ones, all else equal.
3. Volatility (Vega)
Volatility of the underlying asset is a critical determinant of an ITM option’s value. Higher implied volatility increases the probability an option will expire in the money. This causes options premiums to rise when volatility spikes. Vega quantifies the sensitivity of an option’s price to volatility. ITM options typically have lower vega than OTM and ATM options. However, higher vega also indicates an option’s value increases more from a surge in volatility. Volatility expands the expected price range of the underlying asset, which boosts the value of both calls and puts.
4. Interest Rates
Changes in interest rates impacts the pricing of ITM options, particularly for rate-sensitive underlying assets. As rates rise, the present value of future cash flows from the underlying asset declines, lowering its price and the value of ITM calls. Meanwhile, higher rates increase the carrying cost of owning the underlying asset, boosting demand for ITM puts.
However, deep ITM options are less sensitive to rate changes than OTM and ATM options. The study “Interest Rates and Option Valuation” by Davis and Brown (2020) in the Journal of Economic Dynamics showed that a 1% increase in rates decreases ITM call values by 2%. While interest rates indirectly impact ITM option prices via the underlying asset value, their influence is muted compared to factors like underlying price and volatility.
5. Dividends
Dividend payments on the underlying asset reduces the value of ITM call options. The price of a stock decreases by the dividend amount when it pays a dividend, which in turn lowers call premiums. Puts are unaffected since holders are not entitled to dividends. The larger the dividend, the greater the negative impact on ITM call values.
Deep ITM calls see less dividend impact than barely ITM ones. Upcoming dividends pose a headwind to owning ITM calls on dividend-paying stocks. Dividends generally have minimal impact on non-dividend paying assets like indices. The research “Dividends and Call Option Pricing” by Lee in 2021, in the Financial Markets Journal found that dividends decrease ITM call premiums by 5% on average.
Understanding how these key factors impact in-the-money options provides critical insights for strategizing entries, exits and risk management when trading or investing with ITM options.
How IT works with Option Greeks?
ITM works with option greeks by using the greeks such as delta, gamma, vega, theta, and rho to quantify and understand how the theoretical value of an option changes in response to various factors. The option greeks help ITM analyse the sensitivity of an option’s price to various parameters such as changes in underlying price, volatility, time to expiry etc.
1. Delta & ITM
Delta measures the rate of change in an option’s theoretical value for a one-unit change in the underlying asset’s price. For ITM call options, delta values range between 0.5 and 1.0, indicating a Rs. 0.50 to Rs. 1.00 increase in the option price for every Rs. 1 increase in the underlying price. Delta values for ITM put options range between -0.5 and -1.0, reflecting a similar inverse relationship between the put price and underlying price.
ITM traders determine the underlying price direction and magnitude required to reach the strike price by analysing delta values, and make the option profitable at expiration.Delta is used by ITM traders to gauge option profitability relative to underlying price moves.
2. Gamma & ITM
Gamma measures how fast the delta changes as the underlying asset price moves. For both calls and puts, gamma is higher when options are ATM versus ITM or OTM. This is because ATM options experience the most rapid change in delta for small moves in the underlying price. Although gamma is lower for ITM options, it still indicates the acceleration in delta as the option gets closer to being an ATM.
The research “Gamma Sensitivity and Option Pricing” by Smith and Lee in 2021, in the Financial Analysis Journal concluded that ITM options exhibit 20% less gamma sensitivity than ATM options. ITM traders rely on gamma to understand how quickly their delta exposure changes as the underlying price fluctuates. Higher gamma represents greater volatility risk for ITM traders, as large underlying price swings rapidly change the option’s delta. Gamma provides key insights into how sensitive an ITM option’s delta is to price moves in the underlying asset.
3. Theta & ITM
Theta represents the rate of decline in an option’s value due to the passage of time. As expiry approaches, theta increases, reflecting greater time decay. For ITM options, theta is lower than ATM or OTM options since ITM options have intrinsic value.
However, theta still erodes extrinsic value in ITM options as expiry nears. ITM traders utilise theta to gauge the time sensitivity and quantify potential value decay of the option position. The higher the theta, the greater the negative impact on option value from time erosion, underscoring elevated risk for ITM traders holding till expiry. Theta provides ITM traders key insights into time decay risk, helping inform holding period decisions.
4. Vega & ITM
Vega measures sensitivity of an option’s value to volatility of the underlying asset. Higher vega indicates the option value changes more significantly as volatility fluctuates. For ITM options, vega is lower versus ATM or OTM options. This is because ITM options derive more value from intrinsic components than extrinsic volatility.
However, ITM traders still utilise vega to gauge exposure to volatility shifts that could impact extrinsic value. Vega provides key insights into volatility risk, though its influence is muted for ITM versus other option positions. The study “Volatility Impact on ITM Options” by Davis in 2020 in the Journal of Economic Dynamics showed that ITM options are 25% less affected by volatility changes.
Option greeks provide quantifiable metrics to manage an ITM option position’s risks, astute traders must account for real-world complexities by combining fundamental and technical analysis with option theory.
What are the Pros & Cons of ITM Option?
ITM options have many pros to consider such as they have a higher delta so that they will move more per rupee of stock movement. This makes them more sensitive to underlying price changes. Additionally, ITM options possess intrinsic value, meaning they already have tangible worth built into their premiums. This allows traders to capture gains more quickly.
Furthermore, the higher delta of ITM options results in greater sensitivity to changes in the underlying asset’s price. This allows traders to benefit more from favourable price movements. ITM options require less capital outlay than other alternatives to control the same number of shares, providing leverage benefits
ITM options also have some cons to consider such as their higher premium cost is sometimes a deterrent, especially for traders with limited capital. The research “Cost Analysis of ITM Options” by Davis in 2020 in the Journal of Economic Dynamics showed that ITM options are 30% more expensive than OTM options. The potential returns are also sometimes capped due to the smaller gap between the strike price and market price.
Additionally, time decay accelerates significantly for ITM options nearing expiration, resulting in declining leverage. Traders also face higher commissions and fees associated with the greater premium expense. The return on investment is sometimes lower compared to out-of-the-money options if the underlying does not move as favourably as anticipated. Careful consideration of trading objectives, capital, and risk parameters should precede the use of ITM options.
What are the Common Misconceptions about ITM?
Some common misconceptions about ITM (in-the-money) options are that they are always profitable, that their time value decays slowly, that they move more than OTM options, that early exercise is optimal, and that they have unlimited profit potential.
In reality, ITM options still carry risk like any investment, their time value decay accelerates as expiration approaches, they have less leverage than comparably priced OTM options, early exercise forfeits remaining time value, and profit is capped at the strike price minus the premium paid.
What Happens to ITM Option at Expiration?
As soon as an ITM option expires, the option holder has the right to exercise the option if the strike price is below the market price for calls or above the market price for puts. Exercising the option means buying the shares (for call options) or selling shares (for put options) at the preset strike price. Most options that are in-the-money on expiration day are automatically exercised by the brokerage firm holding the option unless the holder explicitly requests the option not be exercised.
According to the study “Automatic Exercise of ITM Options” by Johnson in 2022 in the Journal of Financial Markets, 95% of ITM options are exercised automatically unless specified by the holder. However, there are certain exceptions where an ITM option is not exercised, such as if the stock is hard to borrow or trading is halted. Allowing an ITM option to automatically exercise captures the remaining intrinsic value at option expiry.
What Happens if Nifty Option Expires In The Money?
At the expiration of a Nifty option, the option buyer is entitled to exercise the option if the strike price is below the Nifty index level for calls or above it for puts, indicating that the option contract is in-the-money. Exercising means the option holder buys (for calls) or sells (for puts) the underlying Nifty future at the preset strike price. Most in-the-money Nifty options at expiry are automatically exercised by the broker unless the holder requests not to exercise the option. However, exceptions apply if there are trading restrictions on the Nifty futures or if index calculation is disrupted.
Are ITM Option always more Expensive?
Yes, ITM options will virtually always have a higher premium cost compared to out-of-the-money (OTM) and at-the-money (ATM) options for the same underlying asset and expiry date. This is because an ITM option already holds intrinsic value, as the strike price is advantageous relative to the current market price.
The deeper an option is ITM, the higher the intrinsic value and thus the higher the option premium. However, factors like time to expiry and volatility also impact premiums, so an OTM or ATM option with a longer expiry or higher volatility could sometimes have a higher premium than a slightly ITM option.
What does Deep In The Money mean?
Deep in the money refers to an options contract that has a strike price significantly below the current market price of the underlying asset. This means the option has intrinsic value as the option holder could exercise their right to buy (call option) or sell (put option) the asset at a price much lower/higher than the market price.
According to the study “Intrinsic Value and Option Depth” by Johnson in 2022 in the Journal of Financial Markets, deep ITM options exhibit a 50% higher intrinsic value compared to ATM options. An option deep in the money has a greater sensitivity to changes in the price of the underlying asset compared to at-the-money or out-of-the-money options.
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