What happens if strike price is less than spot price?

When the Strike Price Plays Catch-Up: Understanding In-the-Money Options

In the often-intimidating world of options trading, understanding the relationship between strike price and spot price is crucial for making informed decisions. While many focus on out-of-the-money (OTM) options, let’s delve into what happens when the tables are turned, and the strike price falls below the spot price. This scenario paints a different picture, one of potential profit and immediate intrinsic value.

Recall that a call option grants the holder the right, but not the obligation, to buy an underlying asset at a predetermined price (the strike price) before a specified date (the expiration date). Conversely, a put option grants the right to sell the asset at the strike price.

The In-the-Money (ITM) Scenario: Where Value Resides

The article excerpt correctly states that a call option is OTM when the strike price exceeds the current market price (spot price). But what’s the opposite?

When the strike price is less than the spot price, a call option is considered in-the-money (ITM). This means that the option, if exercised immediately, would yield a profit. Think of it this way: you have the right to buy something for less than its current market value. That right has intrinsic value.

Similarly, a put option is ITM when the strike price is higher than the spot price. You have the right to sell something for more than its current market value.

The Implications of Being In-the-Money

Being ITM has several significant implications for option holders and traders:

• Intrinsic Value: The most obvious is the presence of intrinsic value. The intrinsic value of a call option is calculated as: Spot Price – Strike Price. For a put option, it’s: Strike Price – Spot Price. This intrinsic value directly contributes to the option’s premium (the price of the option contract).
• Higher Premium: ITM options generally have higher premiums than OTM options due to their intrinsic value. This reflects the immediate profit potential they offer. A portion of the premium also comprises “extrinsic value,” which factors in time decay (the erosion of value as the expiration date approaches) and volatility (the expected price fluctuations of the underlying asset).
• Higher Delta: Delta measures the sensitivity of an option’s price to changes in the underlying asset’s price. ITM options tend to have higher deltas, meaning their price will fluctuate more closely with the underlying asset compared to OTM options. This also means they are more expensive to buy, therefore, traders may prefer OTM options in this scenario.
• Exercise Potential: ITM options are more likely to be exercised, particularly near expiration. While option holders can sell their contracts for a profit instead of exercising, exercising becomes more attractive as expiration nears and time decay diminishes the extrinsic value.
• Strategic Use: ITM options are often used in strategies like covered calls (where the option writer already owns the underlying asset) to generate income or in protective puts (where the option buyer wants to hedge against potential price declines).

Trading Activity and the Lure of the “Sweet Spot”

The original text mentions increased trading activity as the strike price approaches the market price. This is generally true. As an option moves closer to being “at-the-money” (ATM) – where the strike price is equal or close to the spot price – it can experience significant fluctuations in both intrinsic and extrinsic value. This increased volatility can attract speculators looking to profit from short-term price swings. However, it’s important to note that liquidity (the ease of buying and selling) also plays a crucial role in trading activity. Options with high open interest (the number of outstanding contracts) tend to be more liquid, regardless of whether they are ITM, ATM, or OTM.

In Conclusion: Know Your Options

Understanding the relationship between strike price and spot price is fundamental to successful options trading. Recognizing when a call option is ITM, and grasping the implications of that state, empowers traders to make more informed decisions, manage risk more effectively, and potentially capitalize on profit opportunities that OTM options simply don’t offer. While the “sweet spot” of trading activity might fluctuate around the ATM mark, the intrinsic value of ITM options remains a powerful and predictable force in the world of derivatives.