Moneyness & Anatomy of Premium (ITM, ATM, OTM)

An option is always in one of three states. It is in the money (ITM), at the money (ATM) or out of the money (OTM). The words apply differently to calls, which give the right to buy, and to puts, which give the right to sell. The picture below shows a ladder of Nifty strikes with the index at 24,500. These are round numbers for illustration.

In the money means the option would give you something if it ended now. For a call, that means the spot price is above the strike. If Nifty is at 24,500, a 24,300 call is in the money by 200 points, because you could buy at 24,300 something worth 24,500. For a put, the opposite holds: it is in the money when the spot price is below the strike. The 24,700 put is in the money by 200 points.

At the money means the strike is equal to, or nearest to, the spot price. Here the 24,500 strike is at the money for both the call and the put. These options are the most sensitive to time and to changes in expected swings, and traders often use them as a reference point.

Out of the money means the option would give you nothing if it ended now. A 24,700 call is out of the money with Nifty at 24,500, because you have no reason to buy at 24,700 something worth 24,500. A 24,300 put is out of the money for the same reason. Such options cost less because you pay only for the chance of the price moving in your favour.

One caution. In the money does not mean profitable, and out of the money does not mean useless. You paid a premium, so an in-the-money option can still lose money if its value is less than what you paid, and an out-of-the-money option can gain if the index moves toward its strike.

The full price of an option, the premium, is the sum of two parts. Premium = intrinsic value + time value. Time value is also called extrinsic value.

Intrinsic value is what the option would be worth if it ended this second. Only an in-the-money option has any. With Nifty at 24,500, the 24,300 call has intrinsic value of 24,500 − 24,300 = ₹200 per unit. Intrinsic value can never be negative. The lowest it can be is zero. Out-of-the-money and at-the-money options have zero.

Time value is the extra amount above intrinsic value that people pay for the chance that the option becomes more valuable. It depends mainly on the days left and on how large a move the market expects. Think of a cricket team that needs 20 runs in 12 balls. It is not yet won, but the chance still has a price. As balls are used up, that price falls, even if the score stays the same.

Here is a worked example. Suppose Nifty is at 24,500 with 30 days left, and the market expects moderate swings (12% annual volatility, about the level in the model used elsewhere in this series). The model gives the 24,300 call a value of about ₹444. Of that, ₹200 is intrinsic and about ₹244 is time value. The 24,500 call is worth about ₹336, all time value. The 24,700 call is worth about ₹247, also all time value.

Notice two things. The at-the-money option has the most time value, because the chance of it ending in the money is the most open. And the cheaper 24,700 call is not a bargain, because every rupee of it is time value, which falls to zero by expiry. An in-the-money option keeps its intrinsic value if the index stays put, but it can also lose that if the index falls back.

Choosing the strike is as important as choosing the direction. It decides how much you pay, how much of the index move reaches your option, how quickly time eats the premium, and how likely you are to end in profit. There is no best strike. Each choice trades one benefit for another.

A deep in-the-money option behaves almost like the index itself. Most of its price is intrinsic value, so time hurts it less, and a move in the index passes to it almost rupee for rupee. The cost is a higher premium, so more money is at risk, and the loss can be large in rupees if the index turns.

An out-of-the-money option needs a small amount of money, so it can give a large return on that money if the index makes a big move toward it. But its whole price is time value, so time eats it fast, and it needs a large and quick move to break even. Many such options expire worthless. That is why people call them lottery tickets. A lottery ticket costs little and pays rarely.

The seller sees the same ladder from the other side. Suppose Nifty is at 24,500 and a seller writes the 24,000 put. The index is 500 points, about 2%, above the strike, and this distance is a cushion. If Nifty stays above 24,000 at expiry the seller keeps the premium. But the cushion is not safety. A fall of more than 500 points makes the seller lose 65 rupees for every extra point, and a sharp fall can come in a single day.