Introduction
Options have no value of their own. The correlation between the strike price and the underlying asset's present market price determines an option's worth. This relationship is called the moneyness of the option. There are three scenarios for this: In the money (ITM), out of the money (OTM), and at the money (ATM).
Let's discuss the third - ATM in detail.
Understanding at-the-money
When the prevailing market price of the underlying asset is equivalent to the strike price, an option is ATM. The strike price is the price at which you can buy or sell the asset using the option.
Let's say you have a call option on XYZ stock. The strike price is Rs 50, and the current selling price of XYZ stock is also Rs 50. Then your option is an ATM. This is also true if you have a put option on XYZ with a strike price of Rs 50 and the market price is Rs 50. ATM options have no intrinsic value, so they are not profitable to exercise immediately. However, they still have some time value, which may increase later if the market price moves in your favour.
How at-the-money options are priced?
The price of the ATM depends upon the following parameters.
- Volatility: It reflects how quickly the price changes of underlying assets. Higher volatility means higher uncertainty and higher potential for profit or loss. It increases the time value of options, increasing the chance that the option may become ITM in the future.
- Interest rates: The cost of borrowing money to buy or sell the underlying asset. Higher interest rates increase call options' time value, making purchasing the underlying asset more expensive. Conversely, it lowers the time value of put options, making the underlying asset cheaper to sell.
- Dividends: Dividends reduce the underlying asset's market price, representing a transfer of value from the issuer to the shareholders. It further decreases the time value of call options, as they make the underlying asset less attractive to buy. Conversely, it increases the time value of put options, making the underlying asset more appealing to sell.
- Time to expiration: The remaining duration of the option contract. Longer time to expiration means more time for the option to become an ITM in the future. Longer tenure increases the time value of options, as it increases the uncertainty and the potential for profit or loss.
How at-the-money options are used in spreads and combinations?
Here are some examples of common spreads and combinations that involve ATM options:
- Straddle: With the same strike price and expiration date, you can make an ATM call and put. This strategy helps profit from a large movement in the underlying price, either up or down, while paying a high premium. The payoff of a straddle is unlimited on both sides, as the option buyer can exercise either the call or the put, depending on the direction of the price movement.
- Butterfly: A butterfly involves buying an ITM call and an OTM call and selling two ATM calls with the same expiration date. The strike prices of the calls are equidistant from each other. A butterfly is used to profit from a small or no movement in the underlying price while paying a low premium. The potential gain for a butterfly strategy is restricted on both ends, as the buyer of the option can only make a profit based on the disparity between the strike prices and the premiums they paid for the options.
- Condor: A condor involves buying an ITM call and an OTM call and selling an ITM call and an OTM call with the same expiration date. The strike prices of the calls are not equidistant from each other but form a range. It is similar to a butterfly but broader, as the option buyer pays a higher premium for the wider range of strike prices. However, a condor also allows a larger movement in the underlying price to be profitable, as the option buyer can profit from the difference between the strike prices and the premiums paid for the options.
Conclusion
In options trading, at-the-money (ATM) options arise when the market price equals the strike price. They lack intrinsic value but retain time value, influencing their pricing. Factors such as volatility and interest rates impact their worth. Strategies like straddles, strangles, butterflies, and condors utilise ATM options for diverse market conditions and profit opportunities, adapting to fluctuations in underlying asset prices.
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