ITM call options play a crucial role in options trading, allowing investors to maximise returns. With their intrinsic value, these options allow investors to capitalise on favourable market conditions.
Understanding the distinction between ITM and OTM call options is also essential for making informed investment decisions and optimising risk-reward ratios. This guide will explore these concepts, and their examples, and highlight their significance in options trading.
An ITM call option, or in-the-money call option, refers to an options contract where the underlying asset’s current price is higher than the strike price, resulting in inherent value.
This means that if the option were to be exercised immediately, the holder could purchase the asset at a price below its current market value. The intrinsic value of this option arises from the profit potential that exists when buying the asset at a discounted price.
ITM call options play a crucial role in trading strategies, especially for traders with a bullish outlook on the underlying asset. These options provide a higher probability of profit due to their intrinsic value. By purchasing it, traders can buy the underlying asset at a discounted price, leading to substantial gains.
This advantage stems from the fact that the current price of the underlying asset is already higher than the strike price, resulting in inherent value.
Compared to out-of-the-money (OTM) call options, which have no intrinsic value, ITM call options offer investors a more favourable starting point. The profit potential is greater with this option type, as it provides a built-in profit margin from the outset.
As a result, traders often prefer call options when they anticipate an upward price movement in the underlying asset, as they offer a higher chance of achieving profitable outcomes.
To identify an in-the-money (ITM) call option, one must compare the strike price of the option with the current market price of the underlying asset. They are the ones where the strike price is lower than the current market price.
This means that if the option was exercised, the investor could buy the underlying asset at a discounted price. Monitoring market movements is crucial in identifying ITM opportunities, as the underlying asset’s market price can fluctuate. Further, option pricing should be closely monitored, as this option will typically have a higher premium due to its intrinsic value.
By staying informed about market trends and analysing options pricing, traders can identify ITM call options and take advantage of favourable buying opportunities.
When considering ITM call options, several key factors come into play. The first is the volatility of the underlying asset. Higher volatility increases the likelihood of the asset’s price surpassing the strike price, making the call option more valuable. Traders should analyse historical volatility and market conditions to assess the potential profitability of an in-the-money call option.
The second factor is the time to expiration. As the expiration date approaches, the time value of the option decreases. This type of option with more time until expiration has a higher chance of becoming even more profitable if the underlying asset increases in value.
Furthermore, dividends and interest rates can impact its pricing and value. If paid out during the option’s lifespan, dividends can reduce the option’s value since the stock price may decrease accordingly. Conversely, higher interest rates can increase the option’s value due to the opportunity cost of holding the underlying asset versus the option.
Lastly, keeping a close eye on market trends and economic indicators is essential. Economic factors, such as GDP growth, inflation rates, and industry performance, can significantly impact the underlying asset’s price and, consequently, the profitability of ITM call options. Awareness of these factors can help traders make informed decisions and capitalise on market opportunities.
The advantages of ITM call options are numerous, making them an attractive choice for traders. Firstly, they have a higher profit probability than out-of-the-money (OTM) options. This is because the underlying asset’s price is already higher than the strike price, increasing the likelihood of the option being exercised and resulting in a profit for the holder.
Another advantage is its immediate intrinsic value. Intrinsic value is the difference between the strike price and the current price of the underlying asset. Since they already have a positive intrinsic value, holders can profit even if the option’s time value diminishes.
ITM call options are also less sensitive to time decay than OTM options. Time decay refers to reducing an option’s value as it approaches its expiration date. They have less time decay because their intrinsic value provides a cushion against the loss of time value.
Lastly, In-the-Money call options offer flexibility in execution strategies. Traders can exercise the option and acquire the underlying asset or sell the option to capitalise on its intrinsic value. This flexibility allows traders to adapt their strategies based on market conditions and investment goals.
While ITM call options offer numerous advantages, it is also important to consider their disadvantages. One significant drawback is their higher premium cost. Because these options have a higher chance of being exercised, they come with a higher initial cost than OTM options.
Furthermore, they require a greater initial investment. Since the strike price is already below the current price of the underlying asset, purchasing them can be more expensive upfront. This may limit the number of contracts a trader can afford to buy.
Another disadvantage is the potentially lower percentage returns compared to OTM options. While ITM call options offer a higher probability of profit, the percentage return on investment may be lower due to the higher premium cost.
To fully understand the difference between in-the-money call options and out-of-the-money (OTM) call options, examining their intrinsic value, premium cost, and risk/reward profile is essential.
ITM call options have a strike price below the underlying asset’s current price. This means there would be an immediate profit if the option were to be exercised immediately. On the other hand, OTM call options have a strike price above the underlying asset’s current price, resulting in no immediate profit if exercised.
Regarding premium cost, they generally have a higher premium cost than OTM options. This is due to the higher probability of ITM options being exercised, leading to a higher initial cost.
Recommended Read: Difference Between OTM, ITM and ATM Options
Regarding the risk/reward profile, they offer a higher probability of profit since they are already profitable. However, the percentage return on investment may be lower due to the higher premium cost. In contrast, OTM call options may have a lower probability of profit. Still, they can offer higher percentage returns if the underlying asset’s price significantly increases.
To summarise the concept of OTM vs ITM, refer to the table below:
In the Money (ITM) | Out of the Money (OTM) | |
Intrinsic Value | Has intrinsic value, as the market price is higher than the strike price. | No intrinsic value, as the market price is lower than the strike price. |
Premium Cost | Higher premium cost due to its intrinsic value. | Lower premium cost as it only consists of time value and volatility. |
Risk/Reward Profile | Lower risk as it is already profitable, but potential returns are limited. | Higher risk as it is not currently profitable, but has unlimited potential returns if the market price rises above the strike price. |
An ITM call option can be valuable for investors looking to gain leverage and increase their returns. However, it is important to thoroughly understand the risks and potential outcomes before investing in any financial instrument.