What Is In The Money?
"In the money" (ITM) is a term used in options trading that describes the condition of an option contract when its strike price is favorable relative to the current market price of the underlying asset. This means the option has intrinsic value and would generate a profit if immediately exercised. The concept of "in the money" is central to understanding the profitability and pricing of options, which are a type of derivatives product.
For a call option, which gives the holder the right to buy an underlying asset, it is in the money when the underlying asset's market price is above the option's strike price. Conversely, for a put option, which grants the right to sell, it is in the money when the underlying asset's market price is below the option's strike price. An option's "in the money" status is a crucial factor in its option premium and overall value.
History and Origin
The concept of "in the money" is as old as options trading itself, which formalized with the establishment of regulated exchanges. Before regulated exchanges, options were primarily over-the-counter contracts, with terms privately negotiated. The modern era of standardized options contracts began with the opening of the Chicago Board Options Exchange (CBOE) in 1973. Cboe Global Markets, Inc., headquartered in Chicago, Illinois, was founded in that year, providing a centralized marketplace for listed options.4 This development allowed for greater liquidity, transparency, and accessibility, enabling concepts like "in the money" to become widely understood and applied in real-time market scenarios. The standardization of terms, including strike prices and expiration dates, was vital for the growth of the options market and the widespread use of analytical frameworks for pricing and evaluating option contracts.
Key Takeaways
- An option is "in the money" when exercising it would result in an immediate profit.
- For a call option, it is ITM if the underlying asset's price is above the strike price.
- For a put option, it is ITM if the underlying asset's price is below the strike price.
- "In the money" options possess intrinsic value, which is the amount by which they are profitable.
- The intrinsic value of an ITM option directly contributes to its overall premium.
Formula and Calculation
The "in the money" status itself doesn't have a formula but indicates the presence of intrinsic value. The intrinsic value is calculated based on the difference between the underlying asset's price and the option's strike price.
For a Call Option:
(Only if Underlying Asset Price > Strike Price; otherwise, Intrinsic Value = 0)
For a Put Option:
(Only if Strike Price > Underlying Asset Price; otherwise, Intrinsic Value = 0)
If the intrinsic value is greater than zero, the option is considered "in the money." The total option premium an investor pays for an option is comprised of its intrinsic value plus its extrinsic value, which accounts for factors like time until expiration and market volatility.
Interpreting the In The Money Status
Understanding whether an option is "in the money" is crucial for investors as it directly relates to the option's current profitability if immediately converted into the underlying asset. An ITM option implies that the market has moved favorably to the option holder's position. This status signals that the option has real, tangible value, distinct from any speculative or time-based value.
For investors, an ITM call option means the holder can buy the underlying shares for less than their current market price, while an ITM put option allows the holder to sell shares for more than their current market price. This provides a direct path to profit and loss should the investor choose to exercise an option. The deeper an option is "in the money," the greater its intrinsic value, making it more valuable to the holder and typically commanding a higher premium. Traders often monitor the ITM status to gauge the effectiveness of their speculation or hedging strategies.
Hypothetical Example
Consider an investor, Sarah, who believes the stock price of Company XYZ, currently trading at $50 per share, will increase. She purchases a call option with a strike price of $45 and an expiration date three months from now, paying an option premium of $6 per share.
A month later, Company XYZ's stock price rises to $55 per share. Let's analyze the call option's "in the money" status:
- Underlying Asset Price: $55
- Strike Price: $45
Since the underlying asset's price ($55) is greater than the call option's strike price ($45), Sarah's call option is "in the money." The intrinsic value of her option is ( $55 - $45 = $10 ) per share. If she were to exercise this option, she could buy shares at $45 and immediately sell them in the market for $55, realizing a profit of $10 per share before considering the premium paid. If she bought one contract, representing 100 shares, the intrinsic value would be ( $10 \times 100 = $1,000 ).
Practical Applications
The "in the money" status has several practical applications in options trading and financial analysis:
- Profitability Assessment: Investors quickly assess an option's immediate profitability. An ITM option has real value that can be captured by exercising or selling the contract.
- Risk Management and Hedging: Traders using options for hedging might look to purchase or hold ITM options to lock in favorable prices for future transactions, thereby mitigating potential losses from adverse market movements.
- Strategy Selection: Various options strategies, from simple calls and puts to complex spreads, rely on specific ITM, at-the-money, or out of the money selections to achieve desired profit and loss profiles.
- Assignment Probability: For option writers, an ITM option indicates a higher probability of being assigned, meaning they might be required to buy or sell the underlying asset.
- Valuation: The intrinsic value component of an ITM option is a direct and measurable part of its overall premium, influencing how the market prices the option. Investors should understand the basics of options trading, including potential risks, before engaging. The U.S. Securities and Exchange Commission (SEC) provides investor bulletins to help educate investors on these topics.3
Limitations and Criticisms
While being "in the money" indicates intrinsic value, it does not guarantee a profitable trade after accounting for the initial cost of the option premium. An option can be ITM, but if the premium paid was higher than the current intrinsic value, the trade might still result in a net loss. This highlights the importance of considering the entire option premium, which includes extrinsic value, when evaluating potential returns.
Furthermore, an option's ITM status can change rapidly due to market volatility or changes in the underlying asset price. An option that is deep "in the money" one moment could become at-the-money or even out of the money if the market moves unfavorably. Therefore, relying solely on the "in the money" status without considering other factors like time decay (part of extrinsic value) and the overall market environment can be a critical limitation in options trading. The Federal Reserve Bank of San Francisco has noted how increased market uncertainty can influence financial conditions and economic activity, which indirectly impacts options pricing and risk.2 Investors must also consider their knowledge and financial ability to bear the risks associated with options trading, as outlined by regulatory bodies.1
In The Money vs. Out Of The Money
The primary difference between "in the money" (ITM) and "out of the money" (OTM) options lies in their intrinsic value and immediate profitability.
| Feature | In The Money (ITM) | Out Of The Money (OTM) |
|---|---|---|
| Intrinsic Value | Has intrinsic value (positive). | Has no intrinsic value (zero). |
| Call Option | Underlying price > Strike price | Underlying price < Strike price |
| Put Option | Underlying price < Strike price | Underlying price > Strike price |
| Profitability | Potentially profitable if immediately exercised, before premium. | Would result in a loss if immediately exercised (or worthless expiration). |
| Premium | Consists of intrinsic value + extrinsic value. | Consists solely of extrinsic value (time value and implied volatility). |
| Exercise | Likely to be exercised an option if held to expiration. | Will expire worthless if still OTM at expiration date. |
Confusion often arises because both ITM and OTM options have a premium. However, the premium of an OTM option is purely composed of its extrinsic value, reflecting the possibility that it could become ITM before its expiration date. An ITM option, in contrast, has immediate tangible value, even if that value is less than the original option premium paid.
FAQs
What does "in the money" mean for a call option?
For a call option, "in the money" means that the current market price of the underlying asset is higher than the option's strike price. This allows the holder to buy the asset at a price below its current market value, creating immediate intrinsic value.
What does "in the money" mean for a put option?
For a put option, "in the money" means that the current market price of the underlying asset is lower than the option's strike price. This allows the holder to sell the asset at a price above its current market value, also creating immediate intrinsic value.
Is being "in the money" always profitable?
Not necessarily. While an "in the money" option has intrinsic value, its profitability depends on the initial option premium paid. If the premium was higher than the current intrinsic value, the trade might still result in a net loss. The option must have enough intrinsic value to cover the initial cost to be profitable.
How does "in the money" relate to option premium?
The option premium for an "in the money" option includes its full intrinsic value plus any remaining extrinsic value. The deeper an option is "in the money," the larger its intrinsic value component, which generally leads to a higher overall premium.