At The Money Options

Introduction

This term along with the terms In-the-Money and Out-of-the-Money are used to describe the relationship between an option’s strike price and the price of its underlying security.  It is important for the option trader to understand these terms in order to assess the potential risks and rewards of any particular option.

When is a call or put option trading at-the-money?

An option is at-the-money when the underlying security is trading at the same price as the option’s strike price.  For example, the QCOM July 50 call and put options will be trading at-the-money as long as QCOM stock is trading at $50 per share.  Although technically an option is at-the-money when the underlying security is trading exactly at the option’s strike price, many industry experts refer to an option as at-the-money when the underlying security is trading close to the strike price.

What are the consequences of allowing a call or put option to expire at-the-money?

Call and put options do not expire at-the-money very often.  It is an extremely rare situation for the underlying security to trade exactly at the option’s strike price when the option expires.  Nevertheless, it is still important for the option trader to understand what will happen should an option expire at-the-money.

When a call or put option expires at-the-money, it always expires completely worthless.  Let’s examine why this is true.  At-the-money options have no intrinsic value, which means that their premiums consist entirely of time value premium.  When a call or put option expires at-the-money, therefore, the option has no intrinsic value and its time value will have been completely exhausted.

What are the advantages of trading at-the-money options?

One advantage of trading at-the-money options is that they are less expensive to purchase than in-the-money options.  In-the-money option premiums include both intrinsic value and time value premium.  Since at-the-money options have no intrinsic value, their premiums are made up entirely of time value premium.  It is the intrinsic value component of in-the-money options which cause their premiums to be more expensive than at-the-money options.  This means then that an at-the-money option will cost less in actual dollars than an in-the-money option.

For example, let’s take a look at the difference in the dollar costs of one contract for an in-the-money, at-the-money and out-of-the-money call option on Starwood Hotels and Resorts (HOT) assuming that HOT is currently trading at $50 per share.

As you can see, the at-the-money March 50 call is less expensive at $185 per contract than the in-the-money March 45 call which costs $560 per contract.  The in-the-money call has time value premium of $60 and intrinsic value of $500.  The at-the-money March 50 call has intrinsic value of $0 and time value premium of $185.

Another advantage of trading at-the-money options is that they will enjoy a higher percentage gain from the same price movement in the underlying security compared to an in-the-money option.  Let’s examine the potential percentage gains for each of the above call options if HOT stock were to increase $1 per share from $50 to $51.

As you can see, the at-the-money March 50 call option would produce a higher percentage gain (27%) than the in-the-money March 45 call option (14%) if HOT stock increased from $50 to $51.  This is true even though the in-the-money March 45 call option would produce a higher gain in dollars ($80) than the at-the-money March 50 call option ($50).

At-the-money options also offer an advantage over out-of-the money options.  An at-the-money option has a greater probability than an out-of-the-money option to expire in-the-money and yield a profit.  This is true because an at-the-money option requires a much smaller increase in the price of the underlying security for it to become in-the-money compared to an out-of-the-money option.

Let’s take a look at the required price increase in HOT stock for an out-of-the-money, at-the-money, and in-the-money call option on HOT to show a profit.  Assume that HOT is currently trading at $50 per share.

As you can see, the at-the-money March 50 call option requires just a $2 rise in the underlying stock to yield a profit, whereas the out-of-the-money March 55 call option requires a $6 increase the stock.  It’s much more likely that the underlying stock will rise by $2 than by $6 over the same period of time.

What are the disadvantages of trading at-the-money options?

The delta value for an at-the-money option will be less than the delta value for an in-the-money option.  This means that an at-the-money option will enjoy a smaller increase in value than an in-the-money option from the same dollar increase in price of the underlying security.  Take a look at the table below for an illustration of this concept.

As you can see, the in-the-money March 45 call option would increase $80 if HOT stock increases from $50 to $51, whereas the at-the-money March 50 call option would increase by only $50 with the same increase in the underlying stock.

Another disadvantage is that an at-the-money option poses a greater risk of loss than an in-the-money option.  At expiration, the in-the-money option will still have intrinsic value, whereas the at-the-money option (and the out-of-the-money option) which has no intrinsic value will have lost all of its time value premium and therefore be completely worthless.  Take a look at the table below for an illustration of this concept.

As you can see, the in-the-money March 45 call option would be worth $5 at expiration if HOT stock was trading at $50, whereas the at-the-money March 50 call option and the out-of-the-money March 55 call option would be worth $0.

Summary

At-the-money options offer more attractive risk/reward characteristics than in-the-money and out-of-the-money options.  At-the-money options require a lower dollar investment per contract and offer a higher potential percentage gain than in-the-money options, and they offer a lower risk of loss than out-of-the-money options.

Category: Options Trading Basics