ITM, ATM, OTM & Option Premium: Understanding Intrinsic Value and Time Value
The three terms (In the money, At the money, and Out of the money) describe the relationship between the strike price of the option and the spot price of the stock or index. Understanding this relationship is one of the most important things in options trading. It directly affects the premium which we pay.
Since we have covered in our earlier post that, every option has a strike price - the fixed price at which you have the right to buy (Call) or sell (Put) the underlying asset. Whether an option is ITM, ATM, or OTM depends on where this strike price sits compared to the current market price or spot price.
Let’s understand each of them one by one.
In-the-Money (ITM)
This option would give the option holder a positive cash flow, if it were exercised immediately. A call option is said to be ITM, when spot price is higher than strike price. A put option is said to be ITM when spot price is lower than strike price.
ITM options usually have a higher premium, because they already carry intrinsic value, not just hope of future movement.
Example: Suppose Nifty is currently trading at 24,000.
A Call option with a strike price of 23,800 is ITM - because we have the right to buy at 23,800, which is cheaper than the current price of 24,000.
A Put option with a strike price of 24,200 is ITM - because we have the right to sell at 24,200, which is higher than the current market price of 24,000.
At-the-Money (ATM)
At-the-money option would lead to zero cash flow if it were exercised immediately. Therefore, for both call and put ATM options, strike price is equal to spot price. In reality, because the strike prices are at fixed intervals of say, Rs.5, Rs.10 or Rs.50, while the spot price moves in much smaller increments, the two prices may rarely be equal. Hence an ATM option can be defined as an option with a strike price which is closest to the spot price.
ATM options are the most actively traded strikes, because they react fast to even small price movements and are commonly used by traders and to calculate implied volatility.
Example: If Nifty is currently trading at exactly 24,000.
The Call option with a strike price of 24,000 is ATM.
The Put option with a strike price of 24,000 is also ATM.
Out-of-the-Money (OTM)
An out of the money option would give the holder a negative cash flow if it were exercised immediately. A call option is said to be OTM, when spot price is lower than strike price. A put option is said to be OTM when spot price is higher than strike price. In our examples, the call option is out-of-the-money.
OTM options are usually cheaper since they don't have intrinsic value, but they also carry higher risk since price needs to move significantly for them to become profitable.
Example: Suppose the Nifty is currently trading at 24,000.
A Call option with a strike price of 24,200 is OTM. because the right to buy at 24,200 isn't useful yet when the market price is only 24,000.
A Put option with a strike price of 23,800 is OTM. because the right to sell at 23,800 isn't useful when the market price is higher, at 24,000.
Why Does This Matter?
Premium cost - ITM options have higher premium since they already carry intrinsic value. OTM options are cheaper but they are riskier.
Probability of profit - ITM options have a higher chance of staying profitable till expiry compared to OTM options, which need a bigger price move in your favor.
Choosing your strategy - Conservative traders often prefer ITM or ATM options for higher probability trades. while traders who wants higher leverage and are willing to take more risk may go for OTM options.
Intrinsic value and time value of option –
The option premium is the combination of intrinsic value and time value.
Premium = Intrinsic Value + Time Value
Intrinsic Value –
The intrinsic value of an option refers to the amount by which the option is in-the-money. Only in-the-money options have intrinsic value whereas at-the-money and out-of-the-money options have zero intrinsic value. The intrinsic value of an option can never be negative because an option holder is not bound to exercise an option if such exercise will result in a loss to him.
· For a call option which is in-the-money, the intrinsic value is the excess of spot price over the exercise price.
· Call option intrinsic value = Current Market Price − Strike Price (if positive, otherwise zero)
· For an in-the-money put option, the intrinsic value is the excess of exercise price over the spot price.
· Put option intrinsic value = Strike Price − Current Market Price (if positive, otherwise zero)
Time value –
It is the difference between the premium and intrinsic value. ATM and OTM options have only time value because the intrinsic value of such options is zero.
Time Value = Premium − Intrinsic Value
Time value is highest when there is adequate time left till expiry, and it gradually drops as the expiry approaches - this gradual decay is called theta decay.
Example: Let’s take a Call option with strike price 23,800, Nifty at 24,000, Intrinsic Value = 200
If this option's premium on our First Demat broking app is showing as 260, then -
Time Value = 260 − 200 = 60
This 60Rs. represents the market's expectation that Nifty might rise even further before expiry, making the option even more valuable.
Now consider an OTM Call option with a strike price of 24,200 which intrinsic Value will be zero. If this option's premium is showing as 45, then -
Time Value = 45 − 0 = 45
Even though this option currently has zero intrinsic value, people are still willing to pay 45 purely as time value - betting that the Nifty could rise above 24,200 before the expiry date.