DEFINITION of ‘Close To Money (CTM)’
Close to money (CTM) option contracts are a subset of in the money (ITM) option contracts, which include a defined number of the closest strike price options having some intrinsic value. Depending upon how an exchange defines its list of CTM contracts, they may include two, three or four options that are nearest to the current market price of the underlying. (See also What Is Option Moneyness?)
BREAKING DOWN ‘Close To Money (CTM)’
The precise definition of CTM contracts may vary from exchange to exchange. In general, they refer to a subset of ITM or contracts which expire with some intrinsic value.
For instance, CTM contracts for call options may include three ITM options strikes immediately below the current market price (or the final settlement price on the expiry day). If a stock is trading at the price of $81 per share, then its three nearest call options having strike prices worth $80, $75 and $70 may qualify to be called as close to money. Similarly, CTM options for put options may include three ITM options strikes immediately above the current market price. In the above example, put options having strike prices worth $85, $90 and $95 may qualify to be called as close to money.
Significance of CTM Contracts
As more and more derivatives contracts are going for physical delivery, the term close to money (CTM) is gaining prominence. Physical settlement means that contracts are settled by delivering the actual underlying stock, and the seller of such ITM call contracts need to deliver the actual security to the buyer through a stock buy position, and the seller of an ITM put option should be ready to receive the security through a stock buy position from the option buyer. This leads to more margin money being required to cover the short option positions. In this scenario, the close to money option positions may need special consideration as they become the borderline cases for being in the money as the contract approaches expiry. For example, over the 15 days period through to the expiry, the underlying stock price may hover in the range of $72 to $82. It leads to a possibility of all the three CTM contracts ($70, $75, $80) having strong chances of settling as ITM, and holders of such options may need additional margins. Therefore, brokers as well as exchanges may impose more margin requirements on their defined set of such CTM options.
In practice, many brokers start with a uniform margin requirement across cash-settled and physically-settled option contracts, say at 30% for short option positions. As the options move closer to the expiry date, the margin requirements for the physically-settled option is increased, to say 50% at 15 days to expiry, and to 80% at 5 days to expiry. Failure to maintain the required margin by the option traders may lead to squaring off the open positions. Depending upon how the underlying stock price moves, the CTM options set is redefined and margin money is released or requested accordingly.
Additionally, security trading is also subject to transaction taxes in a few markets, and may incur other costs such as depository charges. Physical settlement that requires delivery or receipt of actual underlying shares increases such tax liability and associated costs for the option traders, and defining a clear set of CTM options keeps the options trader aware of such additional costs. (See also, Options Pricing: Factors That Influence Option Price.)