Let’s go over how at-the-money options work and how they are valued, as well as learn more about other types of options.
Definition and Examples of At-the-Money Options
At-the-money options are options with strike prices that are equal to the market price of its current underlying stock. Where the option’s strike price is relative to the underlying stock’s price is called “moneyness.” Options can be “in the money,” “at the money,” or “out of the money,” as you’ll learn in more detail below. Options are a contract that gives the buyer the right, but not the obligation, to buy or sell a stock at a strike price by a predetermined date. The right to buy is called a call option and the right to sell is called a put option. Here is a table with examples of information that may be included on an option chain for XYZ stock:
How Does an At-the-Money Option Work?
The moneyness of an option determines what its intrinsic value is. You can then use that information to infer the time value, or extrinsic value, of the option. The value of the option is determined by its intrinsic value, its time value as well as implied volatility. Before we delve into that formula, let’s go over the three types of moneyness. In addition to being at-the-money, options can be in-the-money (ITM) or out-of-the-money (OTM). Call options are considered in the money if the strike price is below the stock price (because the options could be executed for a profit) and out of the money if the strike price is above the stock price. The opposite is true for put options. In the table above, the strike prices below $350 for XYZ stock are in the money for the calls and out of the money for the puts. At-the-money and out-of-the-money options don’t have an intrinsic value, but they do still have a value. That is because there is still a possibility that the option will reach in-the-money status before it expires. That value (and the difference between an in-the-money option’s intrinsic value and the current option price) is called the time value. When you buy an at-the-money option, you’re buying the time value.
How Traders Use At-the-Money Options in a Straddle
At-the-money options are often used in an options trading strategy called a straddle. In a straddle, the trader buys at-the-money calls and puts for the same stock, strike price, and expiration date. The trader is betting that there will be a significant move either up or down. Let’s say a technology company with stock trading for $20 per share has an earnings release approaching. A trader sets up a straddle by purchasing calls and puts with a $20 strike price for $2 each. For the trader to make money, the stock needs to either increase or decrease by $4 per share, which is the total cost of both options. This strategy may seem easy because you can profit whether the stock goes up or down. But in the real world, it’s a little more difficult. For one, when there is more volatility, the price of the options tends to be higher, so it’s more difficult to earn a profit. Like all trading decisions, buying a straddle requires good timing and it is subjective.
How Traders Use At-the-Money Options in a Covered Call Strategy
At-the-money options are also often used in the covered call strategy. Owners of stock can sell call options to generate income. If the buyer exercises the option, they have to sell their stock at the strike price; if the option expires worthless, they get to keep the premium. If you sell a call that is in the money, you’ll likely earn a higher premium, but you could be forced to sell it at a lower price if the option is exercised (and it’s more likely that the option will be exercised). If you sell the call at an out-of-the-money price, it’s less likely to be exercised, but the premium won’t be as high. At-the-money calls are a middle ground, offering potentially attractive premiums and a lower chance of exercise. If an option is at the money at expiration, traders must submit a form to their brokerage requesting exercise of the option. In-the-money options are often automatically exercised if they are far enough in-the-money, but at-the-money options are not. If an option is at the money at expiration, the trader could simply buy the same amount of stock on the open market and forego the process of exercising the option.
