Options: An option contract is said to be ITM (in-the-money) if the option holder would exercise the option if it is the expiration day. Thus, a call option with strike price of Rs.40 is ITM if the ruling spot price is more than Rs.40. This means that the option holder will but the asset at Rs.40 and sell it at the prevailing price and thus make profit.
For a put option to be ITM, spot price has to be lower than the strike price. The following table explains the terms ITM, OTM (Out of - the - money) and ATM (at - the - money).
Situation Call option Put option
1) Strike price > spot price OTM ITM
2) Strike price = spot price ATM ATM
3) Strike price < spot price ITM OTM
Premium: Premium is the price paid by the option buyer to the option seller.Premium is Value of the option.
Option's value consists of two elements namely intrinsic value and time value also known as extrinsic value.
Intrinsic value means the amount to which an option is ITM. Time value represents the additional profit potential that the remaining time to expiry of option is likely to create for the option holder. Hence, as time to expiry nears, time value drops.
Premium = Value = Intrinsic value + Time value. (If a call option premium = Rs.6, Strike price = Rs.40, Spot price = Rs.42, then Intrinsic value of the call option = Rs.2, time value = Rs.4)
Neither intrinsic value nor time value can be negative. They are either positive or zero.
For an OTM or ATM option, there is no intrinsic value. So, for an OTM or ATM, premium = time value.
Following consequences are note-worthy:
1) When an option is ATM, it commands the highest time value.
2) At the time of an option's expiry, the entire value is intrinsic only.
3) Fall in time value occurs at an accelerated pace as expiry draws near.
4) Extreme ITM or OTM option commands negligible time value.
For a put option to be ITM, spot price has to be lower than the strike price. The following table explains the terms ITM, OTM (Out of - the - money) and ATM (at - the - money).
Situation Call option Put option
1) Strike price > spot price OTM ITM
2) Strike price = spot price ATM ATM
3) Strike price < spot price ITM OTM
Premium: Premium is the price paid by the option buyer to the option seller.Premium is Value of the option.
Option's value consists of two elements namely intrinsic value and time value also known as extrinsic value.
Intrinsic value means the amount to which an option is ITM. Time value represents the additional profit potential that the remaining time to expiry of option is likely to create for the option holder. Hence, as time to expiry nears, time value drops.
Premium = Value = Intrinsic value + Time value. (If a call option premium = Rs.6, Strike price = Rs.40, Spot price = Rs.42, then Intrinsic value of the call option = Rs.2, time value = Rs.4)
Neither intrinsic value nor time value can be negative. They are either positive or zero.
For an OTM or ATM option, there is no intrinsic value. So, for an OTM or ATM, premium = time value.
Following consequences are note-worthy:
1) When an option is ATM, it commands the highest time value.
2) At the time of an option's expiry, the entire value is intrinsic only.
3) Fall in time value occurs at an accelerated pace as expiry draws near.
4) Extreme ITM or OTM option commands negligible time value.
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