Options contracts give the holder the right to buy or sell an underlying security at a predetermined strike price for a limited amount of time. If the underlying security is trading at the same price as the strike price of the options contract then the option is said to be trading "at the money."
In general, the price of an option is determined by the relationship of the strike price to the price of the underlying security, the time value of the contract, and the volatility of the underlying security. When an option is at the money, the first of those pricing factors will be equal to zero.
How Traders Use It
If an option is trading at the money, traders will be able to buy or sell the options contract priced solely on the time and volatility factors. Because of that, an at-the-money option can provide a great deal of information to an investor. If an option is not trading at the money, its price will include a cost for the intrinsic value of the relationship between the market price and the strike price, in addition to time and volatility values.
For 30 days, the trader knows that the interest rate is about 0.01%, and given such a low value can assume that the time value of this option is worthless. That means the $10 reflects only the price for volatility in the underlying stock.
A price of $10 indicates that traders think it is very likely that Google will move at least that much over the next month and on an annualized basis, this would be equal to about 20% volatility in the stock. Knowing a value for volatility, traders can then find fair prices for other options available on Google.
In reality, the time value would not be precisely zero and the quoted price of the options contract will include other factors, so this example should be viewed as an oversimplified generalization used for illustrative purposes only.
Why It Matters To Traders
An at-the-money option will allow traders to get an estimate of how the market is valuing the other factors in the options pricing equation. The price of at-the-money options will reflect only the factors associated with the time value and the volatility of the underlying security.
Action to Take --> This presents a simplified approach for traders to determine the market factor for volatility of any underlying security without having access to historic options data and advanced mathematical models.
This article originally appeared on ProfitableTrading.com:
Options 101: At the Money