The premium of each strike is different and is derived from a mathematical formula called as Black-Scholes Model, this is a very complex pricing model, which involves integrations and probability methods. We will not discuss it in detail, however, the Indian Option premium is based on this model.
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In the last lesson, we learned that, to trade in options we can buy/sell CE and PE of rounded prices called strike price.
Depending on the distance between the script price and its strike price, the strike price are categorized into 3 types:
ITM: In the Money ATM: At the Money OTM: Out of the Money
Since CALL (CE) and PUT (PE) are exactly opposite to each other, naturally the definition of ITM, ATM and OTM will also be opposite to each other.
Let’s define ITM for call and put:
ITM CE: If the strike price is less than the current market price, all the strikes are called ITM CE.
ITM PE: If the strike price is more than the current market price, all strikes are called ITM PE.
Example: If the RIL price is Rs 2,331, any strike below Rs 2,331 is ITM CE and any strike above Rs 2,331 is ITM PE.
(Note - Company prices are indicative for educational purposes)
Next, let’s talk about At The Money Strikes,
ATM CE: Any strike close to the current market price is called ATM CE. ATM PE: Any strike close to the current market price is called ATM PE.
Example: If RIL price is Rs 2,232.60, strike Rs 2,331 will be close one, and hence 2340CE and 2340PE will be ATM CE and ATM PE, respectively.
‘Out of The Money’ strikes are opposite to ‘In The Money’ strikes
OTM CE: If the strike price is greater than the current market price, it is called OTM CE. OTM PE: If the strike price is lesser than the current market price, it is called OTM PE.
Example: For Reliance Industries, whose current market price is Rs 2,232.40, any strike greater than Rs 2,232.40 is OTM CE and any strike less than Rs 2,232.40 is OTM PE.
To summarise this is how it looks like on the Option chain :
Agencies
You will notice that the strikes which are ITM for CE are OTM for PE and the strikes which are OTM for CE are ITM for PE.
The reason we differentiate these strikes is due to their premium values and the way they are calculated.
The premium of each strike is different and is derived from a mathematical formula called as Black-Scholes Model, this is a very complex pricing model, which involves integrations and probability methods. We will not discuss it in detail, however, the Indian Option premium is based on this model.
Now as per this model, we differentiate ITM, ATM and OTM by the components used for premium calculations.
As per this model, the option price depends on two values: Extrinsic value and Intrinsic value.
ITM is made up of Extrinsic value + Intrinsic value
OTM is made up of Extrinsic value only.
We will discuss in detail the roles of Extrinsic value and Intrinsic value and its impact on premium pricing in detail in the next lesson.
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)
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(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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