At The Money: Definition, how it works and examples

Deciphering the complexities of financial jargon can often feel like navigating a maze. One such term that frequently pops up in discussions about options trading is "at the money" (ATM). This term holds significant relevance for traders and investors who are looking to understand market dynamics and make informed decisions. Let's unpack what ATM means, why it's important, and how it contrasts with other options trading terms.

What is ‘at the money’ (ATM) and why is it important?

When an option is described as ‘at the money’, it means that the option's strike price is exactly equal to the current market price of the underlying asset. For instance, if a stock is currently trading at Rs. 100, an option with a strike price of Rs. 100 would be considered ‘at the money’. This is crucial for traders because ATM options are highly sensitive to changes in the price of the underlying asset, making them a popular choice for those looking to capitalize on short-term price movements.

The importance of understanding ATM options cannot be overstated. They play a significant role in strategies like straddles and strangles, which are designed to profit from volatility. Moreover, ATM options are often used as benchmarks for pricing other types of options, providing a foundation for more complex financial strategies.

ATM vs ITM and OTM – Understanding the differences

To fully grasp the concept of at the money, it's essential to differentiate it from other related terms: in the money (ITM) and out of the money (OTM). Here's a quick comparison to clarify the distinctions.

Relationship between ATM and the volatility smile

Another fascinating aspect of at the money options is their relationship with the volatility smile. The volatility smile is a graphical representation that shows implied volatility across different strike prices for options with the same expiration date. Typically, the graph forms a smile-like curve, indicating that options are usually more expensive (i.e., have higher implied volatility) when they are either ITM or OTM, compared to when they are ATM.

This phenomenon occurs because traders expect higher movements in the price of the underlying asset when it is far from the current market price. Hence, ATM options, being at the midpoint, often have lower implied volatility. Understanding the volatility smile can help traders make more informed decisions about which options to trade based on their risk tolerance and market outlook.

Simplifying ATM with an example

To understand how at the money options work, let's consider an example. Suppose a stock is trading at Rs. 150, and you purchase an ATM call option with a strike price of Rs. 150. If the stock's price rises to Rs. 160, you can exercise the option to buy the stock at the original Rs. 150, thereby making a profit. Conversely, if the stock's price falls to Rs. 140, the option would expire worthless, and you would only lose the premium paid for the option.

This example highlights the dual-edged nature of ATM options – they offer significant profit potential if the underlying asset moves favorably but also carry the risk of total loss if it moves unfavorably.

ATM – What are its advantages?

One of the primary advantages of at the money options is their high sensitivity to price changes in the underlying asset, known as delta. This makes them an excellent choice for traders looking to capitalize on short-term price movements.

Additionally, ATM options often have lower premiums compared to ITM options, making them more affordable for traders with limited capital.

Another benefit is their versatility. ATM options can be used in various trading strategies, such as straddles and strangles, which can profit from both upward and downward price movements. This flexibility makes them a valuable tool in a trader's arsenal.

Do ATM options have any disadvantage?

Despite their advantages, at the money options also have some drawbacks. One significant disadvantage is their higher risk compared to ITM options. Because their intrinsic value is zero at the onset, ATM options are entirely dependent on the movement of the underlying asset to become profitable. If the asset's price does not move as anticipated, the option can expire worthless, resulting in a total loss of the premium paid.

Conclusion

Understanding at the money options is crucial for anyone involved in options trading. They offer a unique combination of high sensitivity to price changes and affordability, making them a popular choice among traders like you. However, they also come with higher risks and slower time decay compared to other options. Weighing these factors, as a trader, you can make more informed decisions and develop strategies that align with your financial goals.

Disclaimer: This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their own research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.

Investments in the securities market are subject to market risks, read all the related documents carefully before investing. Please read the SEBI-prescribed Combined Risk Disclosure Document before investing. Brokerage will not exceed SEBI’s prescribed limit.