How At-The-Money Options Can Help You Find Winning Trades…
As you may know, options contracts give the holder the right to buy or sell an underlying security.
In general, the price of an option is determined by several relationships. Among the most important are 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.
In both cases of calls and puts, the intrinsic value is the value the option owner could receive right now if they exercised the option. For example, if you own a call at a strike price of $100 and the underlying stock is trading at $105, the intrinsic value is $5 because right now you
could exercise the call, which allows you to buy the stock at the option strike price of $100, and then sell the stock at the current market price of $105, netting $5 in the transaction.
Traders describe options by the relationship of the strike price to the price of the underlying stock in terms of “moneyness”. You may have heard of (or read) terms like “in the money,” “out of the money,” or “at the money”.
Today, we want to spend some time talking about at-the-money options. (But don’t worry, well cover the other two terms as well.) Specifically, we’ll address what they can tell traders about other factors in the options-pricing equation, allowing you to make better-informed decisions…
What Are “At The Money” Options?
For call options, if the stock price is above the strike price, the option is said to have intrinsic value. This is because it allows you to buy the stock at a better (lower) price than someone who doesn’t own options could buy it on the open market. That makes the option in the money (ITM).
For puts, the reverse is true. The option is said to have intrinsic value if the stock price is below the strike price. This is because it allows the holder to sell the stock at a higher price than available on the open market.
An option is out of the money (OTM) when it has no intrinsic value. For calls, this occurs when the strike price is above the stock price. For puts, this occurs when the strike price is below the stock price.
So what if the stock price is equal to the strike price? The option is considered at the money (ATM). It’s important to remember that ATM options have no intrinsic value. Instead, they are “on the verge” of having intrinsic value. Because they could move into the money, allowing the trader to profit since there’s still time to expiration, this can tell us a few important things…
The following table illustrates the point with a fictional “XYZ” stock trading at different prices in relation to its call and put options at a $100 strike price:
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 (theta) and volatility (delta) 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, as well as time, volatility, interest rates, etc. (This is where the other “Greek” options terms come in.)
As an overly simplified example, consider an option on Company XYZ (NYSE: XYZ). 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 XYZ 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 XYZ.
In reality, the time value would not be precisely zero. And the quoted price of the options contract will include other factors to some degree. 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 when they look at other options.
Because the price of at-the-money options will reflect only the factors associated with time value and the volatility, traders can use it to determine the market factor for volatility of any underlying security without having access to historic options data and advanced mathematical models.
This presents a simplified approach for traders. And as you become more familiar with options, you can employ it in your own trading strategy.
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