Why are options very active when they are at the money?

By Matt Lee AAA
A:

Stock options, whether they are put or call options, can become very active when they are at the money. In the money options refer to when the strike price of a call option is below the market price of the underlying stock, and when the strike price of a put option is above the market price of the underlying stock.

At the money means that the strike price is right at the underlying stock's current market price. The activity of options generally increases as the option approaches the declaration date and when the option is at the money.

Options can be used in one of two ways: to hedge against price changes and to speculate on the future market prices of underlying securities. The activity of options while they are at the money may be based on either of these reasons.

Hedging activity usual involves institutional investors. Option trading activity when an option is at the money may mean that the investing institution is taking a married position and hedging against small changes in the stock's market price. For example, assume a hedge fund purchases shares in ZXC Corp. for $35 dollars per share. Twelve months later, ZXC's stock is worth $45 per share. The hedge fund can purchase put options with a strike price of $45, and does so because the fund wants to "guarantee" that the price for which it sells its stock is $45. With this scenario, the fund locks in the return it can get by taking the married put with ZXC stock.

In a speculative situation, an investor believes he can predict an option's underlying stock's price into the future. By purchasing an option that is currently out of the money, there will be a gain if the stock's market price moves in the right direction. For example, assume that an investor purchases a call option for the same company as above (ZXC Corp.) for $1.50 per contract with a strike price of $45; the option is out of the money. The investor waits for 12 months, betting that the stock's price will increase from $35 to more than $45. After the same 12-month period, the stock's price increases to $45, and the option is worth $3.50 per contract. In this scenario, the investor is speculating that the stock price of ZXC will increase over time, and that he will make money on the call option.

To learn more, read our Options Basics Tutorial or The Four Advantages Of Options.

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