What At-The-Money Options Can Tell You
As you may know, options contracts give the holder the right to buy or sell an underlying security. This will be at a predetermined price (known as the “strike price“) and only 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 we are looking at what is known as an “at-the-money” option. (This is in contrast to “in the money” or “out of the money“.)
In general, the price of an option is determined by several relationships. There’s 1) the strike price to the price of the underlying security, 2) the time value of the contract, and 3) 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 At-The-Money Options
Let’s assume an option is trading at the money. This means 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 a trader. 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. (That’s in addition to time and volatility values, of course.)
As an overly simplified example, consider an option on Apple (Nasdaq: AAPL). Let’s say it has 30 days remaining until expiration and is trading at the money. Assume that the option is quoted at $10 a share.
For 30 days, the trader knows that the interest rate is about 0.01%. And given such a low value, we 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 AAPL will move at least that much over the next month. Knowing a value for volatility, traders can then find fair prices for other options available on AAPL.
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 At-The-Money Options Matter To Traders
An at-the-money option allows 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 time value and the volatility.
This presents a simplified approach for traders. Traders use it to determine the market factor for volatility of any underlying security without having access to historic options data and advanced mathematical models.
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