This article is Part 5 of the Futures & Options section of our Stock Market Learning series created by SMJ. Whether you’re a new investor stepping into the world of options trading or an experienced trader refining your strategy, this guide on Choosing the Right Options Strike Price will help you understand the essential concepts of In the Money (ITM), At the Money (ATM), and Out of the Money (OTM) options.
In options trading, selecting the right strike price is a crucial decision that significantly impacts a trade’s outcome.
The strike price represents the fixed price at which the holder of an option contract can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.
For traders in India’s options market, understanding strike prices is essential, as the choice of strike price determines the balance between risk, reward, and likelihood of profit.
When you buy an option, you’ll encounter three primary types of strike prices based on the option’s current market price:
- In the Money (ITM): The strike price is favorable relative to the market price.
- At the Money (ATM): The strike price is equal to the market price.
- Out of the Money (OTM): The strike price is unfavorable relative to the market price.
Each of these categories—ITM, ATM, and OTM—has its own advantages and disadvantages and serves different trading strategies.
For example, ITM options are generally chosen by investors looking for a greater chance of profitability with lower risk, albeit at a higher cost.
On the other hand, OTM options, while cheaper, are riskier and can offer substantial returns only if the underlying asset price makes a significant move in the trader’s favor. ATM options sit in the middle and provide a balance, often suitable for traders anticipating moderate market moves.
The selection of an appropriate strike price depends on several factors:
- Your market outlook: Bullish, bearish, or neutral
- Risk tolerance: Willingness to take on potential losses
- Investment goals: Speculative profit vs. hedging risk
- Time horizon: Short-term vs. long-term expectations for price movement
Also Read: Understanding Open Interest: A Key Metric in Futures and Options Trading
Understanding Strike Price Moneyness: ITM, ATM, and OTM
In options trading, moneyness refers to the relationship between the option’s strike price and the current market price of the underlying asset. This relationship defines whether an option is In the Money (ITM), At the Money (ATM), or Out of the Money (OTM). Understanding moneyness is essential because it impacts both the value of the option and the potential return on investment.
Here’s a closer look at each type of moneyness and how it works:
In the Money (ITM)
- Definition: An option is In the Money (ITM) when it has intrinsic value, meaning it would generate a positive return if exercised immediately.
- For Call Options: The strike price is below the current market price of the underlying asset.
- For Put Options: The strike price is above the current market price.
- Example (India): Suppose Tata Motors is trading at Rs 500.
- A call option with a strike price of Rs 450 is considered ITM because the buyer can purchase Tata Motors shares at Rs 450, below the current price of Rs 500.
- A put option with a strike price of Rs 550 is also ITM because the buyer can sell Tata Motors shares at Rs 550, above the current market price.
- Characteristics: ITM options are typically more expensive than other options due to their intrinsic value. They are often chosen by traders seeking higher probability of gains, albeit with potentially lower percentage returns compared to OTM options.
At the Money (ATM)
- Definition: An option is At the Money (ATM) when the strike price is equal to or very close to the current market price of the underlying asset.
- For Call and Put Options: The strike price approximately matches the current market price.
- Example (India): If Infosys shares are trading at Rs 1,000, a call or put option with a strike price of Rs 1,000 is considered ATM.
- Characteristics: ATM options have no intrinsic value, only time value. They are often used for strategies that anticipate moderate price movements, as ATM options are more sensitive to changes in the underlying asset’s price. ATM options can quickly lose value as they approach expiration if the underlying price does not move favorably.
Out of the Money (OTM)
- Definition: An option is Out of the Money (OTM) when it has no intrinsic value and would result in a loss if exercised immediately.
- For Call Options: The strike price is above the current market price.
- For Put Options: The strike price is below the current market price.
- Example (India): If HDFC Bank is trading at Rs 1,600,
- A call option with a strike price of Rs 1,700 is considered OTM because it does not make financial sense to buy shares at Rs 1,700 when the market price is Rs 1,600.
- A put option with a strike price of Rs 1,500 is also OTM as the market price is higher than the strike price.
- Characteristics: OTM options are generally cheaper than ITM or ATM options because they have no intrinsic value. However, if the underlying asset’s price moves significantly in favor of the option, OTM options can provide large percentage returns. They are popular for speculative trades, especially among traders with smaller capital, but carry a higher risk of expiring worthless.
Also Read: Understanding Call and Put Options: A Beginner’s Guide to Expiry Outcomes
How Moneyness Impacts Option Value and Strategy
Moneyness plays a critical role in defining the value of an option and influences trading strategies:
- ITM Options: Generally chosen by traders with a more conservative approach who want a higher probability of success.
- ATM Options: Preferred by traders expecting moderate price moves and wanting a balanced exposure to the underlying asset.
- OTM Options: Often selected by speculative traders who anticipate significant price movements and are willing to risk smaller amounts of capital for potentially high returns.
Choosing the right strike price in options trading can significantly impact your profitability, especially in a market as dynamic as India’s. The right strike price depends on various factors, including your market outlook, risk tolerance, and investment goals. Here, we’ll examine the key factors to consider when selecting the most appropriate strike price—whether In the Money (ITM), At the Money (ATM), or Out of the Money (OTM)—to help optimize your options trading strategies.
Choosing the Right Strike Price: Factors to Consider
1. Market Outlook
- Bullish Market: If you expect a strong upward movement, consider OTM call options, as they are cheaper and can yield high percentage gains if the stock surges. For a moderate bullish view, ATM options offer a balanced risk-reward trade-off.
- Bearish Market: If you anticipate a significant downward trend, an OTM put option may provide high returns at a lower cost. For moderate bearish views, ATM or slightly ITM put options may be preferable.
- Neutral Market: When expecting minimal price movement, strategies involving ATM options, such as writing calls or puts, could be advantageous. ITM options could also offer more stable returns in sideways markets.
2. Risk Tolerance
- High-Risk Appetite: If you’re comfortable with higher risk, OTM options provide opportunities for large percentage gains, especially if you anticipate substantial price movement in the underlying asset. However, be mindful that OTM options can expire worthless if the target price isn’t reached, resulting in a loss of the entire premium.
- Low to Moderate Risk Appetite: ITM options, though more expensive, have intrinsic value and lower break-even points, making them a safer choice for conservative traders. ATM options can also offer a moderate risk-reward balance, but they are sensitive to time decay.
Example: Suppose Reliance Industries is trading at Rs 2,400, and you have a high-risk appetite. An OTM call option with a strike price of Rs 2,600 may yield high returns if the stock price rises significantly. However, a more conservative trader might choose an ITM call option at Rs 2,300, which has a lower break-even point and higher probability of profitability.
3. Investment Goals
- Speculation: If your goal is to speculate on large price movements, OTM options are typically favored due to their low upfront cost and potential for high returns. However, remember that these come with higher risk.
- Hedging: If you are hedging an existing stock position, ITM options can provide a better hedge by offering more stability and lower sensitivity to time decay.
- Income Generation: For income-focused strategies, such as writing options, ATM or slightly ITM options can be useful due to their higher premiums and balance between risk and reward.
Example: Let’s say you own 100 shares of Tata Motors at Rs 500 per share and want to hedge against potential downside. Buying an ITM put option with a strike price of Rs 520 could help protect your investment by allowing you to sell the shares at a fixed price.
4. Time Horizon and Expiration
- Short-Term Outlook: If your trading horizon is short, ITM options may be more suitable due to their lower time decay and higher intrinsic value. However, they are more expensive.
- Longer-Term Outlook: If you expect the underlying stock to move over a more extended period, OTM options with a longer expiration can provide leverage with lower premiums, though they come with increased time decay risks.
- Managing Time Decay: ATM options are particularly sensitive to time decay, especially as expiration approaches. If holding for a short period, consider the rate of time decay in choosing the strike price.
Example: Suppose you expect Infosys stock to rally from Rs 1,000 to Rs 1,100 over the next month. An ATM or slightly ITM call option would be suitable if you’re looking for short-term gains. For a longer-term outlook, you might consider an OTM option if you expect substantial growth in Infosys stock over six months.
5. Implied Volatility (IV)
- High Implied Volatility: When IV is high, option premiums increase, especially for ATM and OTM options. If volatility is expected to decrease, ITM options can protect against the potential drop in premium.
- Low Implied Volatility: Lower IV can make options cheaper, making OTM or ATM options more attractive. If volatility is expected to rise, these options can appreciate in value even without significant movement in the underlying stock price.
Example: If HDFC Bank has an upcoming earnings announcement and implied volatility is high, ATM options might be pricey. In such cases, choosing an ITM option can reduce the impact of a post-event volatility crush.
6. Break-Even Analysis and Potential Return
- Break-Even Price: Calculate the break-even price for each option to understand how much the underlying asset needs to move for the option to be profitable.
- Return Potential: OTM options generally have higher return potential due to their lower premium cost, though they come with higher risk. ITM options have a lower break-even point but typically offer lower percentage returns.
Example: If you are considering a call option on Nifty 50, trading at Rs 18,000, and purchase an OTM call with a strike price of Rs 18,500, the break-even price would be the strike price plus the premium. For an ITM option at Rs 17,500, the break-even is lower, but the percentage returns may be smaller than the OTM option if the index moves up.
7. Liquidity and Bid-Ask Spread
- Higher Liquidity: Options with high open interest and trading volume often have narrower bid-ask spreads, making it easier to enter and exit positions.
- Lower Liquidity: Illiquid options, often with strike prices further from the current market price, can have wider spreads, which increases transaction costs. Traders should prioritize options with higher liquidity, especially for intraday or short-term trading.
Example: For Bank Nifty options, a popular instrument among Indian traders, selecting an ATM option with high trading volume can offer better liquidity, helping you reduce transaction costs and avoid slippage.
Disclaimer: The information provided on Stock Market Journal is for educational and informational purposes only. While we strive to deliver accurate and current information, it should not be considered financial advice. Stock and options trading involve risks, including the potential loss of principal. Before making any investment decisions, consult a licensed financial advisor or conduct your own research. Stock Market Journal disclaims any liability for financial decisions made based on the information provided here.
