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Understanding In-The-Money (ITM) Options

Writer
Priyansh Bakshi
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May 30, 2024
Understanding In-the-Money (ITM) Call Options: Benefits, Risks, and Strategies

In a call option, you have the right, but not the obligation, to buy a stock for a set price (strike price) by a certain date (expiry date). There are different types of call options, and today we'll focus on In-the-Money (ITM) call options. Let's break it down:

  • Call Option: You're basically hoping the stock price will go up so you can buy it cheap and then sell it for a profit.
  • In-the-Money (ITM): This means the stock's current price is higher than the strike price of your call option.

Example:

Let's say the current price (spot price) of a stock is ₹8,300

  • You buy a call option with a strike price of ₹8,200 (your agreed upon this purchase price)
  • Since the stock price (₹8,300) is higher than your strike price (₹8,200), your call option is In-the-Money (ITM).

Options can be categorized as:

  1. In-The-Money (ITM)
  2. At-The-Money (ATM)
  3. Out-Of-The-Money (OTM)

These terms help investors decide which options to buy or sell.

  • Intrinsic Value: This is the actual value of an option if you used it today. It’s the difference between the current stock price and the strike price.

ITM Options

  • Call Option: ITM if the strike price is lower than the current stock price.

Example: Current stock price is ₹1000, and the call option strike price is ₹900. This option is ITM because ₹1000 (current price) - ₹900 (strike price) = ₹100.

  • Put Option: ITM if the strike price is higher than the current stock price.

Example: Current stock price is ₹1000, and the put option strike price is ₹1100. This option is ITM because ₹1100 (strike price) - ₹1000 (current price) = ₹100.

Option Premium Components

The price you pay for an option (option premium) has two parts:

  1. Intrinsic Value
  2. Time Value

Formula: Option Premium=Intrinsic Value+Time ValueOption Premium=Intrinsic Value+Time Value

Characteristics of ITM, ATM, and OTM Options

  • Intrinsic Value: The real value of an ITM option. It’s the difference between the stock price and the strike price.
  • Time Value: The extra amount you pay because the option might become more valuable before it expires. This value decreases as the expiration date gets closer.

Let’s take another example to understand an ITM Call Option:

An ITM call option has a strike price lower than the current stock price.

Example:

  • Current Price: ₹8300
  • ITM Call Option: Any strike price below ₹8300
  • Example Option: NIFTY FEB 8200 CALL (Strike Price = ₹8200, Current Price = ₹8300)

Benefits of ITM Call Options

  • Lower Risk: ITM options are less likely to expire worthless because the stock price is already in your favor.
  • Good Balance of Leverage and Risk: You can get good returns with a smaller investment compared to buying the stock itself.
  • Less Volatile: ITM options are less affected by sudden market changes compared to other options.

Things to Consider with ITM Call Options

  • Higher Cost: ITM options cost more because they already have some built-in profit potential.
  • Lower Leverage: Higher cost means you have less money left for other investments.
  • Time Decay: As the option gets closer to its expiration date, its value decreases faster.
  • Limited Profit: Your profit is capped at the strike price plus the premium you paid.

Who Should Use ITM Call Options?

  • Investors who are bullish (optimistic) on a stock's price and want to profit from an increase.
  • Investors seeking to hedge (protect) their existing stock holdings.
  • Investors looking for a balanced approach with some level of built-in profit potential and lower risk.

Conclusion

ITM call options can be a powerful tool, but it's important to understand the costs, risks, and limitations before using them. Carefully consider your investment goals and risk tolerance before diving in.

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