Moneyness Explained

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Moneyness

Moneyness is a term describing the relationship between the strike price of an option and the current trading price of its underlying security. In options trading, terms such as in-the-money, out-of-the-money and at-the-money describe the moneyness of options.

In-the-Money (ITM)

A call option is in-the-money when its strike price is below the current trading price of the underlying asset.

A put option is in-the-money when its strike price is above the current trading price of the underlying asset.

In-the-money options are generally more expensive as their premiums consist of significant intrinsic value on top of their time value.

Out-of-the-Money (OTM)

Calls are out-of-the-money when their strike price is above the market price of the underlying asset.

Puts are out-of-the-money when their strike price is below the market price of the underlying asset.

Out-of-the-money options have zero intrinsic value. Their entire premium is composed of only time value. Out-of-the-money options are cheaper than in-the-money options as they possess greater likelihood of expiring worthless.

At-the-Money (ATM)

An at-the-money option is a call or put option that has a strike price that is equal to the market price of the underlying asset. Like OTM options, ATM options possess no intrinsic value and contain only time value which is greatly influenced by the volatility of the underlying security and the passage of time.

Often, it is not easy to find an option with a strike price that is exactly equal to the market price of the underlying. Hence, close-to-the-money or near-the-money options are bought or sold instead.

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This page explains the concept of option moneyness (in the money, at the money, out of the money), how it is determined for call and put options, what it depends on, and what it does not depend on.

The Concept of Option Moneyness

Moneyness, which may sound like a strange word, is a character or state of an option which tells us something about its intrinsic value and the relationship between the option’s strike price and current market price of the underlying stock.

Every option is one of these three cases of moneyness:

  • In the money
  • At the money
  • Out of the money

In option talk these three states are often referred to under acronyms ITM, ATM, OTM. When describing an option strategy, you often hear statements like “buy an ITM call”, “sell an OTM put” etc.

To decide whether an option is ITM, ATM, or OTM, you need to know its strike price, the current underlying price, and also the type of the option, because moneyness is different for calls and puts.

Call Option Moneyness

A call option is:

  • In the money if its strike price is below underlying price
  • At the money if its strike price is equal to underlying price
  • Out of the money if its strike price is above underlying price

Generally, low strike calls are in the money, while high strike calls are out of the money. Calls represent rights to buy the underlying, and you want to buy as low as possible. Therefore, low strike calls are good (in the money), while high strike calls are less valuable.

Put Option Moneyness

It is exactly the opposite with put options, because puts represent rights to sell, and you want to sell as high as possible.

A put option is:

  • In the money if its strike price is above underlying price
  • At the money if its strike price is same as underlying price
  • Out of the money if its strike price is below underlying price

Low strike puts are out of the money, while high strike puts, which when exercised allow you to sell the underlying above the current market price, are in the money.

Characteristics of ITM, ATM, and OTM Options

Each of the three states of moneyness has some common characteristics.

At the money options tend to have greatest time value. They also tend to be among the most actively traded (most liquid).

In the money options are generally more expensive than at the money or out of the money options, because they have intrinsic value. Option premium of ITM options has two components – intrinsic value and time value. Option premium of ATM and OTM options is equal to time value, because their intrinsic value is zero (see note about ATM options below).

In the money options are also most sensitive to changes in underlying price – in Greek talk, they have high positive (calls) or high negative (puts) delta. Out of the money call and put options have delta close to zero. At the money options are something in between.

A Note about ATM Options

In practice, at the money options don’t need to have strike price exactly equal to underlying price. It is quite common to refer to the strike price that is closest to current underlying price as “at the money”, even when it is not exactly equal. For instance, if underlying price is $74.67 and available strikes are $65, $70, $75, $80, $85, the $75 strike call and the $75 strike put would be considered at the money.

As a result, some options may be considered at the money and have non-zero (though very small) intrinsic value. The $75 strike put in the above example has intrinsic value of $0.33 per share.

Deep ITM and Far OTM

The above being said, option moneyness is not really just three states – it is more like a continuous scale. In other words, all ITM options (or all OTM options) are not equal. One in the money option can be more (“deeper”) in the money than another. One out of the money option can be more (further) out of the money than another, if its strike price is further away from the underlying price than the other option’s strike price.

The terms “deep in the money” and “far out of the money” are quite common when option traders describe the degree of moneyness.

What Moneyness Doesn’t Depend on

Option moneyness is determined only by the relationship between its strike price and the current market price of the underlying stock. Nothing else.

Moneyness Doesn’t Depend on Option Premium

Option moneyness does not directly depend on option premium (market price of the option). In general, in the money options have higher premiums than at the money and out of the money options with the same expiration date on the same underlying, but option premium itself does not decide whether an option is in the money or out of the money.

For example, an option trading for $6.50 can be out of the money, while another option (perhaps on a different underlying or with different expiration date) trading for $0.30 can be in the money.

In another example, consider a call option with $50 strike. Let’s say the underlying stock is trading at $49 and the option is trading at $2.00, with 60 days left to expiration. The option is out of the money, because it is a call and its strike price is above current underlying price. One month later, with 30 days left to expiration, the stock is trading at $51 (the option is now in the money), but the option premium is only $1.77 – less than when the option was out of the money one month earlier. This is because an options moneyness and intrinsic value is only one of two components of option premium. The other is time value, which in our example was $2.00 with 60 days to expiration and only $0.77 with 30 days to expiration.

In sum, an option’s moneyness (or more precisely its intrinsic value) affects its premium, but option premium does not affect moneyness.

Moneyness Doesn’t Depend on Your Profit or Loss

When talking about option moneyness, we are not considering initial cost of the option or total profit or loss from an option’s trade. In other words, an option being in or out of the money does not tell you whether you have made or lost money trading the option.

You can exercise an in the money option and still end up losing money if you have initially bought the option for more than what you gain from exercise. For example, you buy a $20 strike call option for $2. The underlying stock is trading at $21 close to expiration – the option is in the money by $1. You decide to exercise the option, get the stock for the $20 strike and immediately sell it in the stock market for $21. You gain $1 from the exercise, but overall, after your initial cost, you lose $1. An in the money option doesn’t mean automatic profit.

Conversely, you can sell an out of the money option and make a profit if you initially bought the option for less. You can even buy an option when it is out of the money and later sell it when it is out of the money, but has higher premium, therefore you make a profit from that trade. This is admittedly an unlikely case, which would require very short holding period and sharp increase in implied volatility that would offset the loss of intrinsic value.

In any case, option moneyness is not about you profit or loss from a trade. It does not depend on current option premium or your initial cost of buying the option. It should also be clear by now that moneyness also doesn’t depend on volatility or time to expiration.

Moneyness depends on the relationship between strike price and underlying price only.

What Is Option Moneyness?

In the money, at the money and out of the money refer to moneyness, an aspect of options trading that has important implications. This article covers the basic concepts of option valuation, which is critical in understanding moneyness.

Elements Of Option Pricing

A typical option quote contains the following information:

  • Name of the underlying asset – i.e. shares or contracts
  • Expiration date – i.e. December
  • Strike price – i.e. 400
  • Class – i.e. call

Another important element is the option premium, which is the amount of money that the buyer of an option pays to the seller for the right, but not the obligation, to exercise the option. This should not be confused with the strike price, which is the price at which a specific option contract can be exercised.

The above elements work together to determine the moneyness of an option – a description of the option’s intrinsic value, which is related to its strike price as well as the price of the underlying asset. (For more on the fundamentals of options trading, see our Essential Options Trading Guide.)

Intrinsic Value And Time Value

The option premium is broken down into two components: intrinsic value and speculative or time value. The intrinsic value is an easy calculation – the market price of an option minus the strike price – representing the profit the holder of the option would book if he or she exercised the option, took delivery of the underlying asset and sold it in the current marketplace. The time value is calculated by subtracting the intrinsic value of the option from the option premium.

In-The-Money Options

For example, let’s say it’s September and Pat is long (owns) a December 400 call option for ABC. The option has a current premium of 28 and ABC is currently trading at 420. The intrinsic value of the option would be 20 (market price of 420 – strike price of 400 = 20). Therefore, the option premium of 28 is comprised of $20 of intrinsic value and $8 of time value (option premium of 28 – intrinsic value of 20 = 8).

Pat’s option is in the money. An in-the-money option is an option that has intrinsic value. With regard to a call option, it is an option with a strike price below the current market price. It would make the most financial sense for Pat to sell her call option, as she would receive $8 more per share than by taking delivery and selling the shares in the open market.

Deep-in-the-money options present profitable opportunities for traders. For example, buying a deep-in-the-money call option can present the same profit opportunity in terms of dollars as purchasing the actual stock but with less capital investment. This translates into a much higher return. Selling deep-in-the-money covered calls presents a trader with the opportunity to take some profit immediately, as opposed to waiting until the underlying stock is sold. It also can be profitable when a long stock appears to be overbought, as this would increase the intrinsic value and often the time value, due to the increase in volatility.

Out-Of-The-Money Options

Returning to our example, if Pat was long a December 400 ABC put option with a current premium of 5, and if ABC had a current market price of 420, she would not have any intrinsic value (the entire premium would be considered time value), and the option would be out of the money. An out-of-the-money put option is an option with a strike price that is lower than the current market price.

The intrinsic value of a put option is determined by subtracting the market value from the strike price (strike price of 400 – market value of 420 = -20). Intuitively, it looks as if the intrinsic value is negative, but in this scenario, the intrinsic value can never be lower than zero.

At-The-Money Options

A third scenario would be if the current market price of ABC was 400. In that case, both the call and put options would be at the money, and the intrinsic value of both would be zero, as an immediate exercise of either option would not result in any profit. However, that doesn’t mean that the options have no value because they may still have time value.

The Importance Of Time Value

Time value is the main reason there is little exercising of options but a considerable amount of closing out, offsetting, covering and selling of shares or contracts. In our example, Pat would have increased her profit by 40% ($8/$20) by selling her call option instead of taking delivery of the stock and selling the shares. The $8 covers the speculation that exists in regard to the price of ABC between September and expiration in December.

The market determines this part of the premium but it is not a random assessment. Many factors come into play in the establishment of the time value of an option. For example, the Black-Scholes option pricing model relies on the interplay of five separate factors:

  1. Price of the underlying asset
  2. Strike price of the option
  3. Standard deviation of the underlying asset
  4. Time to expiration
  5. Risk-free rate

The Bottom Line

Understanding the basics of valuing options is part science and part art. It is vital to understand where profits come from and what they represent in order to maximize option trading returns.

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