In The Money Options

| February 28, 2012 | 0 Comments

In the Money OptionsThis term along with the terms Out-of-the-Money and At-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 option in-the-money?

A call option is in-the-money when the option’s strike price is less than the price of the underlying security.  In other words, you could exercise the option and buy the underlying security at a price below its current trading price.  A call option is said to be out-of-the-money when the option’s strike price is greater than the price of the underlying security.  Of course, an at-the-money call option has a strike price that is equal to the price of the underlying security.

The following table illustrates when a call option is in-the-money, at-the-money, and out-of-the-money.  Assume that ABC stock is trading at $50 per share.

Option Description
Strike Price
Stock Price
Option Status
ABC July 45 call
45
50
in-the-money
ABC July 50 call
50
50
at-the-money
ABC July 55 call
55
50
out-of-the-money

 

What happens when a call option is in-the-money at expiration?

The Options Clearing Corporation (“OCC”) will automatically exercise any call option based on an individual stock if the option expires in-the-money by $0.05 or more.  Similarly, the OCC will automatically exercise any index based call option that expires in-the-money by $0.01 or more.  Be advised that any individual brokerage firm may have a different threshold than the OCC’s for the automatic execution of in-the-money equity and/or index options.  An investor may provide special instructions to the OCC through their brokerage firm prohibiting the automatic exercise of call or put options that expire in-the-money by any amount.

 

How does one calculate the intrinsic value and time value premium of an in-the-money call option?

The intrinsic value of an in-the-money call option is the amount by which the price of the underlying security exceeds the option’s strike price.  The formula for calculating the intrinsic value of an in-the-money call option is as follows:

Call Option Intrinsic Value = Stock price – Strike Price

A call option that is out-of-the-money has a strike price that is higher than the price of the underlying security and therefore its intrinsic value is zero.  Of course, the intrinsic value of an at-the-money call option is zero as well since the stock price and strike price would be the same.

The time value premium of an in-the-money call option is the amount by which the price of the option (commonly referred to as “premium”) exceeds the option’s intrinsic value.  The simple formula for computing the time value premium of a call option is as follows:

Call Option Time Value Premium = Option Price + Strike Price – Stock Price

Example:  ABC is trading at 58 and the ABC July 55 call is priced at 4.  The option’s premium is 4.  The intrinsic value (the amount by which the option is in-the-money) is 3 (58 – 55), and the time value is 1 (4 – 3).

If the call option is out-of-the-money or at-the-money, then the option premium and the time value premium will be the same.  This is true because the intrinsic value of at-the-money and out-of-the-money options is zero.

The following table illustrates the difference between in-the-money, at-the-money, and out-of-the money call options with regard to intrinsic value and time value premium.  Assume that ABC is trading at 50, the ABC July 45 call is priced at 6, the July 50 call is priced at 2 and the July 60 call is priced at 1.

Option Description
Strike Price
Stock Price
Option Premium
Intrinsic Value
Time Value Premium
ABC July 45 call (ITM)
45
50
6
5
1
ABC July 50 call (ATM)
50
50
3
0
3
ABC July 55 call (OTM)
55
50
1
0
1

 

When is a put option in-the-money?

A put option is in-the-money when the option’s strike price is greater than the price of the underlying security.  Notice that this situation is the opposite of the call option.  An out-of-the-money put option has a strike price that is less than the price of the underlying security.  A put option is at-the-money when its strike price is equal to the price of the underlying security.

The following table illustrates when a put option is in-the-money, at-the-money, and out-of-the-money.  Assume that ABC stock is trading at $50 per share.

Option Description
Strike Price
Stock Price
Option Status
ABC July 55 put
55
50
in-the-money
ABC July 50 put
50
50
at-the-money
ABC July 45 put
45
50
out-of-the-money

 

What happens when a put option is in-the-money at expiration?

The Options Clearing Corporation (“OCC”) will automatically exercise any put option based on an individual stock if the option expires in-the-money by $0.05 or more.  Similarly, the OCC will automatically exercise any index based put option that expires in-the-money by $0.01 or more.

Be advised that any individual brokerage firm may have a different threshold than the OCC’s for the automatic execution of in-the-money equity and/or index options.  An investor may provide special instructions to the OCC through their brokerage firm prohibiting the automatic exercise of call or put options in their account which expire in-the-money by any amount.

 

How does one calculate the intrinsic value and time value premium for an in-the-money put option?

The intrinsic value of an in-the-money put option is the amount by which the option’s strike price exceeds the price of the underlying security.  The formula for calculating the intrinsic value of an in-the-money put option is shown below:

Put Option Intrinsic Value = Strike Price – Stock Price

The intrinsic value of an at-the-money put option is zero since the strike price and underlying stock price are the same.  An out-of-the-money put option has a strike price that is lower than the price of the underlying security and therefore its intrinsic value is zero as well.

The time value premium of an in-the-money put option is the amount by which the option’s premium exceeds the option’s intrinsic value.  The formula for determining the time value premium of an in-the-money put option is somewhat different from that of an in-the-money call option:

Put Option Time Value Premium = Put Option Price + Stock price – Strike price

Example:  ABC is trading at 57.  The ABC July 60 put is priced at 5.  The intrinsic value is 3 (60-57).  Therefore, the time value premium is 2 (5 + 57 – 60).

If a put option is out-of-the-money or at-the-money, it’s time value premium is equal to the entire option premium.  This is true because the intrinsic values of out-of-the-money and at-the-money put options is always zero.

The following table illustrates the difference between in-the-money, at-the-money, and out-of-the money put options with regard to intrinsic value and time value premium.  Assume that ABC stock is trading at 60, the ABC July 65 put is priced at 7, the July 60 put is priced at 3, and the July 55 put is priced at 1.

Option Description  
Stock Price
Strike Price
Price Option Premium
Intrinsic Value
Time-Value Premium
ABC July 65 put (ITM)
60
65
7
2
5
ABC July 60 put (ATM)
60
60
3
0
3
ABC July 55 put (OTM)
60
55
1
0
1

 

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

In-the-money options offer higher deltas than at-the-money and out-of-the-money options.  This means that an in-the-money option will increase in value at a greater rate than at-the-money and out-of-the-money options for each $1 increase in the underlying stock price.  Take a look at the table below for an illustration of this concept.  Assume that ABC stock is trading at $100 per share.

 

Option Description
Stock Price
Strike Price
Delta
Gain if Stock Moves Up $1
ABC July 95 call (ITM)
100
95
0.70
$70
ABC July 100 call (ATM)
100
100
0.50
$50
ABC July 105 call (OTM)
100
105
0.30
$30

As you can see, the ABC July 95 call option has a higher delta and therefore would enjoy a greater increase in value compared to the at-the-money and out-of-the money options for the same $1 increase in price of the underlying stock.

 

Another advantage is that the risk of losing money on an in-the-money option is lower than it is for at-the-money and out-of-the-money options.  This is true because an in-the-money option will have intrinsic value at expiration if the underlying stock price remains unchanged.  At-the-money and out-of-the-money options do not have intrinsic value; they will expire worthless if the underlying stock price does not increase in value.  For example, assume that ABC stock is trading at $100 per share at the time of purchase of one option contract and does not change prior to the option’s expiration date.

Option Description
Stock Price
Strike Price
Delta
Gain if Stock Moves Up $1
Value At Expiration
ABC July 95 call (ITM)
100
95
0.70
$70
$5
ABC July 100 call (ATM)
100
100
0.50
$50
$0
ABC July 105 call (OTM)
100
105
0.30
$30
$0

As you can see, the in-the-money option retains intrinsic value at expiration and therefore the contract still has value.  The at-the-money and out-of-the-money options have no intrinsic value and therefore these contracts have no value at expiration.

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

In-the-money options cost more in dollar terms per contract than at-the-money and out-of-the-money call options due to their intrinsic value.  As discussed above in the section on intrinsic value and time value premium, the price of an in-the-money option will include both time value and intrinsic value.  At-the-money and out-of-the-money options do not have intrinsic value; their option premiums are made up of time value premium alone.  For example, assume that ABC stock is trading at $100 per share.

Option Description
Stock Price
Strike Price
Option Premium
Cost per Contract
ABC July 105 call (OTM)
100
105
1
$1 x 100 shares = $100
ABC July 100 call (ATM)
100
100
3
$3 x 100 shares = $300
ABC July 95 call (ITM)
100
105
7
$7 x 100 shares = $700

 

As you can see, the cost per contract of the in-the-money call option is higher than the cost per contract of both the at-the-money and out-of-the-money call options.

 

Another disadvantage of trading in-the-money options is that they provide a lower percentage gain than at-the-money and out-of-the-money options for the same move in the price of the underlying stock.  For example, assume that ABC stock is trading at $100 per share when each option below is purchased and increases to $150 per share at expiration.

Option Description
Strike Price
Option Premium
Cost per Contract
Gain at Expiration
ABC July 105 call (OTM)
105
1
$100
$45/$100 = 45%
ABC July 100 call (ATM)
100
3
$300
$50/$300 = 16.7%
ABC July 95 call (ITM)
105
7
$700
$55/$700 = 7.8%

As you can see, the 7.8% gain on the in-the-money call option is lower than the respective 16.7% and 45% gains on the at-the-money and out-of-the-money call options.

Category: Options Trading Basics

About the Author ()

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.

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