What is ITM Full Form in Trading and Options Contract?

When you purchase a stock, you are expecting its value to increase over time so that, at a later date, you’ll be able to sell it at a higher price. An alternative approach, however, would be to buy a call option for that stock. This gives you the right to buy the stock at a price you fix now (called the strike price), as long as you do it within a designated timespan (called the expiry). Thus, if your options contract has a strike price for the stock of $30, you’d be allowed to buy it at that price before expiry even if the actual market price shoots up to $50 a share. In other words, through locking in a price on the asset, you would have created leverage for yourself in ultimately trading it, (since you’d be paying $20 below the market price). For this reason, bullish traders find call options particularly appealing.

When an options contract is ITM, it means that the strike price is currently below the market price (in the case of a call option). The ITM full form in trading is “in the money”, which essentially means that a certain amount of leverage is already baked into the contract. If your call option allows you to buy an asset at a price that is, even at this moment, below its market value, you could immediately turn around and sell it to your own advantage. That’s one reason why options traders are willing to pay more for a contract that is ITM than for one that is ATM (at the money, meaning the strike price and market price are equal) or OTM (out of the money, meaning that the strike price is above the market price). An ITM call option possesses intrinsic value in the sense that it could produce earnings for you right now. Even as the expiry date approaches, this contract will retain its value (as long as market prices remain above the strike price). By contrast, a contract that is OTM loses all value at the time of expiry.

Does all this mean that ITM options contracts carry no risk? And does it imply there’s no reason someone would hold onto an options contract that is OTM? Stay with us to find out.

Premiums

The premium is the amount you pay when purchasing an options contract. How much will this cost you? Like any other asset, it depends on how valuable traders consider it to be. When it comes to options, this is determined by how much people expect the contract could earn them down the line. One important factor in setting the prices of premiums is whether the contract is ITM, ATM, or OTM. Understandably, if the stock is ITM, meaning that it contains intrinsic value, this will tend to push up the premium you’ll pay to buy it. For someone buying a contract that is OTM, the relationship between the strike price and market price would have to reverse for it to earn them money. That’s why you’d pay less of a premium for it. If you had good reason to believe that the market price would rise above the strike price – say, because the company is employing a new CEO – it may be worthwhile to buy the OTM contract at a discount.

There are two other factors that contribute to setting the premium value: time to expiry and asset volatility. Taking the case where there is plenty of time until expiry, this could bump up the premium because there is more of a chance the option could shift from OTM to ITM, or grow even more ITM. And when we are dealing with an asset that behaves in a volatile fashion, this also indicates to traders that further price movements in the future could push the contract into ITM territory. Thus, they may pay more for an options contract on a volatile instrument than a stable one.

Risks of Options Contracts

Based on what we’ve said, you can see how not every call option you purchase, even if it’s ITM, is guaranteed to make you money. That contract may carry intrinsic value now, but the underlying asset is continually fluctuating and will do so until expiry. It’s very possible that, within that time, the option will shift from being ITM to OTM. All that has to happen is for the market price to drop below the strike price for the intrinsic value to disappear.

Anyone who buys a call option for a stock knows he’ll have to lay out more money on the premium if it’s ITM. This itself detracts from the potential earnings accruing from the contract. Take the example of a stock currently trading at $24 a share, where the strike price for a call option on it holds at $20. Since each options contract applies to a 100-share lot, the intrinsic value of the call is $400 (100 times $4). However, if the premium on the call was $4.50 per share, (due to it being ITM) the total premium cost would amount to $450 (100 times $4.50). We have, then, a case where the option is ITM, but its intrinsic value is wiped out by the premium. Thus, the question of whether or not buying an ITM option will yield you earnings depends on the premium you’ll be paying. More fundamentally, it depends on share prices indeed rising within the designated time period or, at the least, not falling below the strike price.

This brings us to reconsider the fact that you paid a higher premium for an option on a volatile stock when the expiry is distant. The presumption was that the volatility, within the expanded time frame, would work in your favor through nudging prices higher. But volatility is also a risk. It could very well work against you through depressing the market price below the strike price. In the event this occurs, you would have paid extra for something that ultimately diminished your chances of making money. This is a reason to be wary of the idea that, since you paid a higher sum for the premium, you must have bought a more lucrative instrument. Remember that nobody really knows the trajectory of the underlying asset. Especially in our times, asset prices are easily disturbed by news items, geopolitical tensions, economic reports and more.

ITM Put Options

Buying a put option gives you the right to sell an asset at a given price before expiry, even if market prices drop in the meantime. If the asset is presently trading at $35 a share, and the strike price for your put option on it is $40 a share, the put option is ITM. This is because it possesses intrinsic value in allowing you to earn a higher sale price than anyone selling the asset directly could get. In other words, since we are dealing here with selling and not buying an asset, the criterion of ITM is defined by the contract price exceeding the strike price, not undershooting it.

In this case, the seller of the options contract will be hoping the asset’s prices rise rather than fall. If they do rise, you won’t end up exercising your put option and the seller will get to keep the premium you paid. From your perspective, it’s desirable, not just that prices go down, but they drop enough to cover your premium expense. Whether you’re holding a put option or a call option, if expiry arrives and your contract is still ITM, you can make money through exercising it. On the other hand, if it has shifted to OTM by expiry, your contract is worthless.

Concluding Thoughts

Even though your put or call option might end up worthless, the good news is that the most you could lose is the premium. At worst, you won’t exercise your option, and the options seller will keep what you paid upfront. Compare this with somebody who bought lots of real stock, only for its value to plummet in the following weeks. His losses could multiply very quickly to unmanageable levels.

Many traders will trade in options if there’s some reason to expect a big price movement down the line, for example a company earnings report or a product launch. If the expectation is for prices to surge on this event, he would buy a call option on the stock. This would allow him to buy it at a discount and sell it after it spikes. If the anticipated event doesn’t bring about this effect, it need not be the end of the world, as long as the premium he paid was reasonable.