At any given moment during its lifetime, an option is either In the Money (ITM), At the Money (ATM) or Out of the Money (OTM). An In the Money option is therefore only one of the 3 options ‘moneyness’ states.
A trader who understands how options are priced will find it easier to understand the concept of an option being In the Money. An ITM option is one that has both intrinsic value and extrinsic value. The biggest part of an option’s extrinsic value consists of time value,
although there are other components such as volatility and interest rates.
All options have extrinsic value when they are sold. ITM options, however, differ from ATM and OTM options in the respect that it also has intrinsic value. What follows is a brief explanation of this concept.
ITM call options and intrinsic value
A call option, which gives the owner the right to purchase the underlying asset at a price below the current market price, is said to have intrinsic value.
If the shares of Company ABC are therefore trading at $30 at present and a trader buys an ITM call option with a strike price of $20, that option gives the trader the right to buy ABC shares at $20 instead of the going rate of $30.
This difference of $10 is called the intrinsic value of the call option. The initial price of the option will, however, be higher than $10. The first $10 of its price will be the intrinsic value. Apart from that there will also be an extrinsic element, depending on the time to expiration, the volatility and interest rates. The actual value of the option might therefore be something
If at expiration date the price of ABC shares is still $30, the option will not be worthless as would be the case with an ATM or OTM option. It will only lose the extrinsic value, which in this case was $3 ($13 – $10). The option would at expiration therefore still be trading at $10. This is why ITM options are often considered to be safer for beginner traders than ATM or OTM options.
ITM put options
Put options are considered to be In the Money (ITM) when their strike price is above the current market price of the underlying asset.
Going back to the example above, if company ABC shares are trading at $30 at present, a put option with a strike price of $40 would be $10 in the money, because it allows the owner to sell shares of Company ABC for $40 while the going market price is $30.
If the share price of Company ABC remains stagnant at $30 between now and the expiration date, the $40 strike ITM option would still be trading at its intrinsic value of $10 by expiration.
Delta of ITM Options
In the Money options have a higher Delta than either ATM or OTM options. This means they follow movements in the price of the underlying much more closely than the latter. If the option is kept to expiration, this plays no role, however.
Fig. 8.29(a) provides an overview of how ITM options relate to OTM and ATM option. Notice that ITM calls are below the current market price and ITM puts are above the current market price.