Near the Money
In the world of finance and trading, the term “Near the Money” (NTM) is used primarily in the context of options trading. Understanding this concept is crucial for traders who are involved in options contracts, as it directly influences strategies and decision-making processes regarding potential profits and risks associated with these financial instruments.
Definition and Explanation
“Near the Money” refers to an option whose strike price is very close to the current trading price of the underlying asset. This term can be applied to both call and put options:
- Call Option: Gives the holder the right, but not the obligation, to buy the underlying asset at the strike price.
- Put Option: Gives the holder the right, but not the obligation, to sell the underlying asset at the strike price.
For an option to be considered “Near the Money,” its strike price should be as close as possible to the current market price of the underlying asset, yet not exactly the same (which would be “At the Money”).
Near the Money vs At the Money vs Out of the Money
To paint a clearer picture:
- At the Money (ATM): The option’s strike price is exactly equal to the current price of the underlying asset.
- In the Money (ITM): For call options, strike price < current price; for put options, strike price > current price.
- Out of the Money (OTM): For call options, strike price > current price; for put options, strike price < current price.
“Near the Money” serves as an intermediary stage where the strike price is neither close enough to be “At the Money” nor sufficiently advantaged in the case of “In the Money” options.
Practical Use in Trading Strategies
Straddles and Strangles
Straddles
- When a trader buys a call and put option with the same strike price and expiration date.
- Ideal when expecting significant volatility but uncertain of the price direction.
- For a successful strategy, the underlying asset’s price needs to deviate sufficiently from the strike price to cover the cost of both options.
Strangles
- A variation that involves purchasing a call and put option with different strike prices but the same expiration.
- Commonly, the options are near the money, but with slightly different strikes to reduce the cost of the trade.
- Offers a similar strategy to straddles but can be more cost-effective.
Hedging
Options Near the Money are also instrumental in hedging existing positions. Traders might use NTM options to protect against small adverse price movements while keeping premiums relatively low. For example, an equity portfolio manager could buy NTM put options to insure against minor downturns in stock prices without inflating hedging costs excessively.
Bull and Bear Spreads
- Created with calls (Bull Call Spread) or puts (Bull Put Spread).
- Investors buy NTM options and sell OTM options.
- This strategy is employed when a moderate rise in the underlying asset’s price is expected.
Bear Spreads
- Created with calls (Bear Call Spread) or puts (Bear Put Spread).
- Investors sell NTM options and buy OTM or further NTM options.
- This strategy is employed when a moderate decline in the price of the underlying asset is expected.
Key Considerations
Implied Volatility and Greeks
Near the Money options are particularly sensitive to changes in implied volatility. Since NTM options are close to becoming either ITM or OTM based on small price movements, they possess higher “vega,” denoting sensitivity to volatility changes. Additionally, Greeks like delta and theta offer significant insights:
- Delta: Measures the change in the option’s price relative to a change in the underlying asset’s price. NTM options typically have deltas close to 0.5, meaning they capture half of the price movement.
- Theta: Indicates the rate of time decay in the option’s value. NTM options can lose value quickly as expiration approaches, emphasizing the importance of timing in trading.
Time Decay
Given their placement on the price spectrum, NTM options experience notable time decay. As the expiration date approaches without significant price movement in the underlying asset, the value of these options erodes rapidly. Traders must be diligent in managing positions and deciding optimal entry and exit points to mitigate adverse effects of time decay.
Liquidity
NTM options usually exhibit high trading volumes and liquidity. This makes them attractive for traders who require the flexibility to execute trades quickly and at favorable prices. Market makers and institutional investors often focus on NTM options due to their strategic importance in trading portfolios.
Examples in Practice
Apple Inc. (AAPL)
Consider Apple Inc. (AAPL) trading at $150 per share. If an investor buys a call option with a strike price of $149 and expiration date in one month, this option would be considered Near the Money. The decision to enter this position might be driven by an expectation of minor, positive price movements in AAPL stock, with potential gains if the stock price surpasses $149 plus the option premium by expiration.
Tesla Inc. (TSLA)
Suppose Tesla Inc. (TSLA) is trading at $700 per share. An investor might create a strangle by buying a call option with a strike price of $720 and a put option with a strike price of $680, both expiring in three months. If Tesla’s price moves significantly in either direction due to an earnings announcement or product launch, the payoff from the strangle can offset the combined premiums and generate profit.
Conclusion
Understanding and utilizing “Near the Money” options is a pivotal skill in the toolkit of modern traders. These options present a balance between risk and reward, integrating effectively into diverse trading strategies ranging from speculative plays, hedging purposes, to spread trading. Mastery of this concept demands a solid grasp of underlying price movements, volatility, and the impact of time decay. Additionally, leveraging NTM options mandates a strategic approach towards asset management, aligning trade executions with market conditions and individual risk tolerance levels.