At the money (ATM) Options

Purab Kumar -

Options trading can be a complex and confusing topic, but one important concept to understand is At the Money (ATM) options. ATM options are a type of options contract where the strike price is approximately equal to the current market price of the underlying asset. In this article, we will explore the definition, characteristics, pricing, and strategies for trading ATM options.

Definition and Characteristics of ATM Options

An ATM option is a contract where the strike price is equal to the current market price of the underlying asset. For example, if the stock price of XYZ Bank is INR 1,500, then an ATM call option would have a strike price of INR 1,500 and an ATM put option would also have a strike price of INR 1,500. This means that the option has no intrinsic value since it is not "in the money" or "out of the money." Instead, the option's value is determined by its time value, which is based on the amount of time until the option expires, as well as other factors such as implied volatility and interest rates.

Understanding the Concept of Intrinsic Value and Time Value in ATM Options

Intrinsic value is the difference between the strike price and the current market price of the underlying asset. In the case of ATM options, the intrinsic value is zero since the strike price is equal to the current market price. Instead, the value of ATM options comes from its time value, which is based on how much time is left until the option expires. Time value is the amount of money that traders are willing to pay for the option in the hope that the underlying asset's price will move in their favor before the option expires.

How ATM Options are Priced in the Market

The price of an ATM option is based on several factors, including the price of the underlying asset, the strike price, the time remaining until expiration, implied volatility, and interest rates. Options traders use complex mathematical models to calculate the theoretical price of the option, which takes all of these factors into account.

Factors Affecting the Value of ATM Options

Several factors affect the value of ATM options, including:

  1. Implied volatility: ATM options are particularly sensitive to changes in implied volatility since they have no intrinsic value. Higher implied volatility generally means a higher option price, while lower implied volatility generally means a lower option price.
  2. Time decay: ATM options have a high rate of time decay since they have no intrinsic value. As the option approaches expiration, its time value decreases, which can cause the option price to decrease as well.
  3. Interest rates: Interest rates can affect the price of ATM options since they affect the cost of carry. Higher interest rates generally mean a higher option price, while lower interest rates generally mean a lower option price.

Advantages of Trading ATM Options

  1. Lower cost: Since ATM options have no intrinsic value, they are generally less expensive than ITM options, which can make them an attractive option for traders with limited capital.
  2. Higher liquidity: ATM options are highly liquid, which means that traders can easily buy and sell them at the current market price.
  3. Limited risk: Since the cost of an ATM option is lower than an ITM option, the risk of losing a significant amount of money is also lower.

Disadvantages of Trading ATM Options

  1. Limited profit potential: ATM options have limited profit potential since they have no intrinsic value. If the underlying asset's price doesn't move significantly in the desired direction, the option may expire worthless.
  2. High rate of time decay: ATM options have a high rate of time decay, which means that they lose value quickly as they approach expiration. This can make it difficult to profit from ATM options if the underlying asset doesn't move quickly in the desired direction.

Strategies for Trading ATM Options

There are several strategies that traders can use when trading ATM options, including:

  1. Long call: This strategy involves buying an ATM call option with the hope that the underlying asset's price will increase before the option expires.
  2. Long put: This strategy involves buying an ATM put option with the hope that the underlying asset's price will decrease before the option expires.
  3. Short straddle: This strategy involves selling an ATM call option and an ATM put option simultaneously. Traders who use this strategy are hoping that the underlying asset's price will remain stable and that both options will expire worthless.
  4. Covered call: This strategy involves selling a call option on an underlying asset that the trader already owns. By selling the call option, the trader can earn extra income while still retaining ownership of the underlying asset.

Real-Life Examples of Trading ATM Options

Let's take a look at a few real-life examples of trading ATM options in the Indian market.

  1. Long call example: Suppose that Reliance Industries' stock is currently trading at INR 2,000, and a trader buys an ATM call option with a strike price of INR 2,000 for INR 50. If the stock price increases to INR 2,100 before the option expires, the trader can sell the option for a profit of INR 50 (INR 2,100 - INR 2,000 - INR 50 = INR 50).
  2. Long put example: Suppose that Infosys' stock is currently trading at INR 1,500, and a trader buys an ATM put option with a strike price of INR 1,500 for INR 40. If the stock price decreases to INR 1,450 before the option expires, the trader can sell the option for a profit of INR 10 (INR 1,500 - INR 1,450 - INR 40 = INR 10).
  3. Short straddle example: Suppose that Tata Steel's stock is currently trading at INR 1,000, and a trader sells an ATM call option and an ATM put option simultaneously for a total premium of INR 80. If the stock price remains stable at INR 1,000 before the options expire, the trader can keep the entire premium of INR 80.

Conclusion

At the Money (ATM) options are a popular type of options contract that can offer traders a lower-cost and higher-liquidity alternative to in-the-money (ITM) options. While ATM options have limited profit potential, they can be an attractive option for traders with limited capital or those looking to manage their risk. By understanding the advantages and disadvantages of ATM options and using effective trading strategies, traders can potentially profit from trading these options in the Indian market.

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