What Is In-the-Money Option?
An in-the-money option refers to an option contract that holds intrinsic value, meaning it has an immediate profit if exercised. This concept is central to options trading, a specific area within financial derivatives. For a call option, which grants the holder the right to buy an underlying asset, the option is in-the-money if 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 if the underlying asset's market price is below the strike price. An in-the-money option is desirable because it suggests a favorable position relative to the current market.
History and Origin
The concept of options, including those considered in-the-money, has roots extending centuries, with informal over-the-counter options traded in the United States as early as the 1790s. Early options markets were often controlled by "put-call dealers" who would advertise offerings in newspapers.8 However, the modern era of standardized, exchange-traded options, which brought formal definitions and consistent trading, began with the establishment of the Chicago Board Options Exchange (CBOE) on April 26, 1973.,7 This marked a significant shift from the manual, bilaterally negotiated options that existed previously.6 The CBOE introduced a centralized marketplace and standardized terms, which facilitated clearer pricing and the development of more complex options strategies.5 Concurrently, The Options Clearing Corporation (OCC) was founded in 1973 to provide clearing and settlement services for options, becoming the world's largest equity derivatives clearing organization and playing a crucial role in ensuring market integrity and stability.4
Key Takeaways
- An in-the-money option possesses intrinsic value, meaning it would result in a profit if exercised immediately.
- For a call option, it is in-the-money if the underlying asset's price is higher than the strike price.
- For a put option, it is in-the-money if the underlying asset's price is lower than the strike price.
- Being in-the-money implies a favorable position for the option holder, but the total value also includes time value.
- Investors often seek in-the-money options for their immediate value, particularly when looking to capitalize on existing price movements.
Formula and Calculation
The intrinsic value of an in-the-money option is determined by the difference between the underlying asset's current price and the option's strike price. This intrinsic value is a component of the total option premium.
For a call option to be in-the-money:
(Only if Current Stock Price > Strike Price; otherwise, Intrinsic Value is 0)
For a put option to be in-the-money:
(Only if Strike Price > Current Stock Price; otherwise, Intrinsic Value is 0)
If an option has an intrinsic value greater than zero, it is considered an in-the-money option.
Interpreting the In-the-Money Option
An in-the-money option indicates that the option holder is currently in a profitable position if they were to exercise the option. The greater the difference between the underlying asset's market price and the strike price, the "deeper" in-the-money the option is, and generally, the higher its intrinsic value. While an in-the-money option has intrinsic value, its total option premium also includes time value. This time value erodes as the option approaches its expiration date. Therefore, interpreting an in-the-money option involves assessing both its intrinsic value and the remaining time value to understand its full worth and potential for further appreciation or depreciation.
Hypothetical Example
Consider XYZ stock trading at $105 per share.
Scenario 1: Call Option
An investor holds a call option for XYZ stock with a strike price of $100. Since the current stock price ($105) is higher than the strike price ($100), this call option is in-the-money.
The intrinsic value would be:
This means for every share covered by the option contract, there is an immediate $5 of intrinsic value.
Scenario 2: Put Option
Another investor holds a put option for XYZ stock with a strike price of $110. Since the current stock price ($105) is lower than the strike price ($110), this put option is in-the-money.
The intrinsic value would be:
In this case, the investor could sell the stock for $110, even though its market price is $105, realizing an immediate $5 gain per share.
Practical Applications
In-the-money options are frequently used in various options trading strategies. They are commonly employed by investors for speculation when anticipating significant price movements in the underlying asset. For example, a trader bullish on a stock might buy deep in-the-money call options to gain leveraged exposure, mimicking the stock's price movement more closely than out-of-the-money options. Conversely, a bearish trader might buy in-the-money put options.
These options are also vital for hedging existing positions. An investor holding a stock might buy in-the-money put options as a form of portfolio insurance to protect against a potential downturn, ensuring a minimum selling price. The Securities and Exchange Commission (SEC) provides guidance to investors on the basics and risks associated with options trading, highlighting their use as derivatives that derive value from an underlying asset.3 In practice, platforms like Webull highlight various strategies involving different types of options, including those that are in-the-money, for different trading goals.2
Limitations and Criticisms
While an in-the-money option provides immediate intrinsic value, it's crucial to consider its full option premium, which includes time value. A common criticism or limitation is that in-the-money options are generally more expensive than their out-of-the-money or at-the-money counterparts due to their embedded intrinsic value. This higher cost means a larger initial capital outlay, which can increase the potential for a larger percentage loss if the market moves unfavorably and the option's value declines.
Furthermore, the value of an in-the-money option is still subject to the passage of time. Even if an option is deep in-the-money, its time value erodes as it approaches its expiration date. This time decay, also known as theta, can diminish the option's overall value, particularly for options with less time remaining until expiry. Models like the Black-Scholes model, widely used for pricing options, make certain assumptions that can lead to theoretical values deviating from actual market prices, especially under volatile market conditions or specific macroeconomic shifts, highlighting a general limitation in perfectly predicting option behavior.1,
In-the-Money Option vs. Out-of-the-Money Option
The primary distinction between an in-the-money option and an out-of-the-money option lies in their intrinsic value. An in-the-money option has intrinsic value; it would be profitable if exercised immediately. This means that for a call option, the underlying asset's price is above the strike price, and for a put option, the underlying asset's price is below the strike price.
Conversely, an out-of-the-money option has no intrinsic value. If exercised immediately, it would result in a loss or be worthless. For an out-of-the-money call option, the underlying asset's price is below the strike price, while for an out-of-the-money put option, the underlying asset's price is above the strike price. Confusion often arises because both types of options can still have time value and be actively traded. The difference is their current profitability upon exercise. In-the-money options are typically more expensive than out-of-the-money options due to their immediate value, but both can be used for various options trading strategies depending on an investor's outlook and risk tolerance.
FAQs
What does "in-the-money" mean for a call option?
For a call option, being in-the-money means the current market price of the underlying asset is higher than the option's strike price. This indicates that the option has intrinsic value.
What does "in-the-money" mean for a put option?
For a put option, being in-the-money means the current market price of the underlying asset is lower than the option's strike price. This also indicates that the option has intrinsic value.
Do in-the-money options always result in profit?
Not necessarily. While an in-the-money option has intrinsic value at any given moment, the total option premium paid for the option must also be considered. If the premium paid was higher than the option's intrinsic value at expiration, the trade might still result in a loss, even if the option expired in-the-money. Profit depends on the option's value exceeding its initial cost.
Can an in-the-money option lose value?
Yes, an in-the-money option can lose value. Its total price includes both intrinsic value and time value. As the option approaches its expiration date, its time value diminishes. If the underlying asset's price moves unfavorably (e.g., the stock price drops for a call option), the intrinsic value can also decrease, potentially leading to a total loss in the option's value.