In the text below, we try to explain the differences between in-the-money, at-the-money and out-of-the-money options.
Definitions of ITM, ATM and OTM
At the very beginning, in order to successfully trade binary options contracts, it is extremely important for any trader to understand each of these terms and what they mean in practice. This has great practical weight when trading as the type of option you trade determines completely different financial outcomes when you interact with these financial instruments. We believe that the following article will effectively help you understand the meaning of the different types of binary options contracts. Acquiring a basic package of knowledge about ITM, ATM and OTM variants will open you the possibility to make more informed and strategic choices in the field of trading with the use of binary options.
In this publication, we will focus on explaining the following topics:
What is in-the-money?
What is at-the-money?
What is it out-of-the-money?
Examples of ITM, ATM and OTM binary options
What are binary options in-the-money (ITM)?
In the context of a payout, an in-the-money binary options contract can be spoken of whenever the indicative market is above the strike price by at least one tick or point.
The mathematics that governs binary options trading dictates that if you trade options contracts of the ITM type, you consequently have the best chance of making money from your investment. This is due to the fact that in this variant there are as many as three ways to make a profit:
The indicative price keeps moving up.
The indicative price moves down but stays above the strike.
The market stays flat.
From a practical point of view, the primary limitation when buying ITM binary options contracts is the higher bid/offer price. This is because the deal is already in-the-money and your chance of profit is definitely higher.
Of course, whenever you decide to trade binary options in this model, you will have a lower profit potential primarily due to the higher bid/offer price. The profit on binary options contracts is always calculated from $100, so if you have paid more for the contract, your profit potential is understandably lower. Let's illustrate this with a simple example. If you pay $80 for an ITM contract, your potential profit will be $20 ($100 - $80). If you only pay $40 per contract, then your profit potential per trade is $60. What is important at this point is that each time the profit potential is calculated without fees.
What are binary options at-the-money?
By default, an at-the-money binary option contract is considered to be in variant when the final outcome is closest to the strike price. Most often, the purchase cost is around $50 as it is equally likely to become ITM or OTM. In the practice of trading binary options, there is only one contract considered to be an ATM, while as a rule there can be several OTM and ITM contacts. You should always be aware that a binary options contract cannot expire at a price with respect to payout criteria. Since the strike price mechanism for binary options is that it is framed as "greater than", it consequently has to be one tick or point above the strike price for it to ultimately be classified as an ITM. In any case, if the final result is not greater than the strike price, but exactly equal to its value, then from the point of view of profit payout, the option is considered an OTM. You need to keep this in mind especially when the option is close to expiration. This is because in this case just one tick can have a decisive impact on the settlement of the entire contract.
What are binary options out-of-the-money?
A binary options contract is out-of-the-money whenever the current market is below the strike price. This type of binary options is chosen by traders who assume that the current market will be below the strike price on the date and time set in the terms of the option. In this model, investors who sell the contract have a much better chance of winning.
In this case, a trader who is interested in selling a previously purchased contract can gain in three ways:
The underlying market moves lower.
The underlying market stays the same.
The underlying market moves higher but expires at or below the strike price
There are many effective strategies for trading binary options contracts. Under certain market conditions, in some cases you may want to buy ITM binary options contracts where you will pay a commission for a higher probability of profit. During other market parameters you may decide to buy binary options contracts in the OTM variant where you secure the trade with less money. This will make you less likely to make a successful trade. This is an excellent strategy if you think there will be a lot of movement in the market.
Before trading binary options, be aware that there is no right or wrong way to trade this derivative whether it is ITM, ATM or OTM. Any types of strategies that you use should primarily take into account the current and anticipated market situation and the potential profits you intend to achieve.