At-the-money (ATM) option plays an important role in option trading. It is, therefore, important to define an ATM strike. In this article, we discuss how to “fix” the ATM strike in the real-world markets. We also show why an ATM option is important for trading.
A common understanding is that an ATM option is a strike that equals the current price of the underlying. So, if the underlying trades at 500, the 500 strike is the ATM option.
Conceptually, based on an option valuation model, an ATM option is a strike that has a delta of 0.50. Note that delta captures the change in the option value for a one-point change in the underlying. So, the value of an ATM option is expected to change by 0.50 point for every one-point change in the underlying price.
The model will assign a delta of 0.50 to a strike that is closest to the underlying price at option expiration. How will you know today what the underlying price will be an expiration? Suffice to understand that the model interprets this is as the forward price of the same maturity as the option contract. So, if the current price of an underlying is 500 and its three-month forward price is 505, then the model will assign a delta of 0.50 to the three-month 505 strike option.
Does this mean you always have to check the option delta to pick the ATM option? Yes, if you want to be true to the model. But we trade derivatives that have short maturities. So, the forward price based on the model will not be significantly different from the current price of the underlying. Hence, it is convenient to accept that ATM is a strike that equals the current price of the underlying.
Of course, you have to modify the above definition for trading purposes because NSE follows a strike interval programme. For instance, it offers strikes in intervals of 50 on the Nifty Index. So, if the current value of the Nifty Index is, say, 15893, NSE will not offer a strike at 15893. This means ATM option can only exist when the value of the Nifty Index is exactly at one of the strikes offered by the NSE. But it would be meaningful to have an ATM option always because that would provide a context for in-the-money (ITM) and out-the-money (OTM) strikes.
So, for practical purposes, we will consider the strike closest to the current spot price as the ATM option. Therefore, if the current value of the Nifty Index is 15893, then 15900 will be the ATM option. Based on this argument, it is possible that we may consider an ITM option to be an ATM strike. For instance, if the Nifty index were to trade at 15815, then the 15800 call would be deemed as ATM even though it is an ITM option with 15 points of intrinsic value.
Why the fuss about ATM option? For one, the ATM option is the focal point of the implied volatility rule and the liquidity rule to choose strikes for setting up trading strategies. For another, the ATM option has the highest vega, highest gamma and, therefore, also the highest theta; this follows from the ATM option being highly sensitive to change in the volatility of the underlying. You can observe this by analysing the option Greeks using an option calculator, which you can find on the Internet.
Translating this to a trading strategy, you should prefer an ATM option if you expect the volatility of the underlying to increase, or short an ATM option during the expiry week when you have a view that the underlying is likely to move sideways. In both scenarios, the ATM option should give you greater profits than ITM or OTM strikes.
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