In the Money Option
In the money (ITM) option is an option which has positive value and whose holder is better off exercising such option.
A call option is in the money when the price of the underlying asset is higher than the exercise price. It is because the option holder can purchase the underlying asset under the option contract at the exercise price and then sell it at the higher price prevailing in the market thereby generating a profit.
A put option on the other hand, is in the money when the price of the underlying asset is lower than the exercise price. It is because the option holder can sell the underlying asset under the option contract at the exercise price which is higher than what he would have otherwise received in the market.
A binary option is in the money when the event triggering exercise takes place.
An option is in the money over a range of the price of the underlying asset. If it is not in the money, it is either at the money or out of the money. An in the money option does not mean that the option holder made net profit on the option. There are situations in which the proceeds/gain from exercise of an option is not enough to pay off the premium paid to purchase that option.
Example 1: The following extract shows call and put option mid-quotes on stock of Advanced Micro Devices Inc. (NYSE: AMD) as at close of market on 19 July 2013 obtained from Morningstar.
|Exercise Price||Call Value||Put Value|
Closing price of AMD as at 19 July 2013 was $4.03. You can follow from the table that the call option value is positive as long as the exercise price is below the price of the underlying asset. The call option is in the money at $2.5, $3.0, $3.5 and $4.0. The put option on the other hand, has positive value at instances when the exercise price is higher than the price of the underlying asset, i.e. at $4.5, $5.0 and $5.5.
Example 2: On 11 July 2013, Mihai Cirstea purchased 100 call options on AMD stock for $200. They carried an exercise price of $2.5 and were due to expire on 19 July 2013.
Find the total profit or loss Mihai made on the trade on the day before expiration.
From the table in Example 1, we know that a call option on AMD stock with exercise price of $2.5 was worth $1.53 [higher of zero or ($4.03 minus $2.5)] just before expiration. The options were in the money and Mihai would generate $153 by exercising them [= $1.53 × 100].
However, since the proceeds from exercise of options are not enough to cover the $200 premium he paid on 11 July 2013, he will have a bear a loss of $47 on the whole transaction [= $200 premium paid minus $153 recovered at the time of exercise]. Please note that this does not mean Mihai should have let the options expire. If he had opted not to exercise them, his losses would have been $200.
Written by Obaidullah Jan, ACA, CFA