One question that is asked frequently is what happens when an OTM option becomes ITM? How does it impact the option price? Well, let me explain that briefly here.
When an option is ITM, its price comprises of two components: intrinsic value and time value. On the other hand, when an option is OTM, its price comprises of only time value while intrinsic value is zero. As a result, an ITM option will be more expensive than an OTM option. For instance, notice the below screenshot of Nifty Options Chain.
See above that the 17400 call, which is notably ITM, has a price of 343.9; while the 18050 call, which is notably OTM, has a price of just 13. For put options, it’s the other way around. The 18050 put, which is notably ITM, has a price of 327; while the 17400 put, which is notably OTM, has a price of just 9.45.
If you buy an OTM call and the underlying price rises, the call premium will rise, all else equal. However, as the option is OTM, the pace of rise will be slow as Delta will be less than 0.5. When the option moves from OTM to ITM, its intrinsic value will move from zero to positive, increasing its price further. The higher the underlying price rises above the strike price, the higher will be the intrinsic value of the call and subsequently its premium. Also, as the call moves from OTM to ITM, its delta will rise from below 0.5 to above 0.5. The higher the underlying price rises above the strike price, the higher will the delta move above 0.5 (the maximum it can rise is 1). Hence, as the option moves ITM, its premium will become more responsive to changes in the underlying price. As a buyer of an OTM call, you would want the underlying price to rise and move past the strike price, so as to bolster your returns. On the other hand, as a seller of an OTM call, you would want the underlying price to remain sideways or, better yet, decline so that you get to keep the premium received.
For put options, it’s the other way around.
We have talked about the concepts of option moneyness as well as how the Greeks interact when the underlying price changes in relation to the strike price. To read more about Options, visit the Options module in FYERS School of Stocks. To be redirected to the Options module, click https://fyers.in/school-of-stocks/module/options.html