You have probably heard the following terms: in-the-money, at-the-money, and out-of-the-money.
These terms refer to moneyness, which is an important term to understand if you are entering the world of options trading. In this article, we’ll discuss the basic concepts of option moneyness.
What is option moneyness?
Moneyness refers to how the strike price of the option relates to the current trading price of the underlying asset.
In other words, moneyness describes the intrinsic value of an option in its current state.
Options are classified by traders into three categories based on the relationship of the strike price to the underlying stock price at the current time. The categories describe an option’s moneyness.
It’s important to get a handle on these categories and what they mean before you start trading options. Every options strategy will incorporate these terms and without a solid understanding, beginners can easily find themselves confused.
The three types of option moneyness are:
- In-The-Money (ITM)
- Out-Of-The-Money (OTM)
- At-The-Money (ATM)
Moneyness in single options contracts is a fundamental concept to master when trading options. Moneyness does get more complicated once you start to add sophisticated options strategies to the mix, so it’s important to take the time early on to establish a basic understanding.
Three categories of moneyness
Each of the three categories is driven by the relationship between the current stock price and option strike price.
ITM does not mean that the trader is going to make a profit necessarily, but instead describes the position of the strike price against the stock price at any given time.
For example, if you have a call option and the stock price is greater than the strike price, that option is said to be in-the-money and has intrinsic value. It’s just describing the relationship between the two prices and not the trader’s actual profitability. If you have a put option and the stock price is lower than the strike price, then your position is in-the-money.
In the image above, assume you have a $100 call option. If the stock is trading for $105, you could exercise the option and immediately sell the shares for a profit. Therefore, the option is in-the-money (with $5 of intrinsic value in this example).
Again, OTM doesn’t mean the trader has lost money on a trade but is simply a generic description of where the strike and stock prices are in relation to each other at present.
For a call option position to be considered OTM, the stock price would need to be lower than the strike price; for a put option, the stock price would need to be higher than the strike price.
Options are ATM when the strike price and stock price are at the same level, whether you are trading calls or puts. It describes a price level parity between stock and strike prices.
Determining the value of the option
An option’s pricing is based on two components:
- Intrinsic value
- Extrinsic value
Intrinsic value is the value of an option if it expired at this very moment.
- When traders say an option is in-the-money, they are saying it has intrinsic value.
- Out-of-the-money options has no intrinsic value.
- When traders say that the contract has expired worthless, it’s because an option expired out-of-the-money.
The relationships between ITM, OTM, and ATM are all used to help determine the intrinsic value of the option, which is a key factor in option pricing.
It is important to look at a trade and ask this question:
- If this option were to expire today, would it have any value?
- If yes, then the option has intrinsic value.
Remember: out-of-the-money options have no intrinsic value.
Although extrinsic value plays a less prominent part in moneyness, it is an important concept to understand when trading options.
Extrinsic value has several components. Time value, or theta, is the portion of an option’s premium that is attributable to the amount of time remaining until the contract's expiration. Although it's not the only component, time value is receives the most attention.
As with most things, time is money. In this case, time is value.
Typically, the more time that remains until expiration, the higher the extrinsic value of the option. Investors will pay a higher premium for additional time since the contract will have longer to achieve profitability from a favorable move in the underlying asset.
And the reverse is true. When there is less time remaining until expiration, investors are less willing to pay a premium, because the stock has less time to become profitable.
Option moneyness examples:
For a call option, the option is be in-the-money if the strike price is below the current value of the stock trading in the market.
In this example, we have a $100 strike call option.
The option is ITM if the stock price is higher than $100 because you can buy the stock for $100 when it is trading at $110 ($10 of intrinsic value).
However, you can see in the grey shaded area that although the option is in-the-money, it is not above the break-even price (the strike price + the cost of the option) and is still a losing position. The position is profitable when the underlying stock price exceeds the strike price and the cost of the option contract ($5 in this example).
Extrinsic value may cause the position to be profitable even if it is below the break-even price, but that depends on where the stock price was when you purchased the option. Note that payoff diagrams are used to determine profitability at expiration.
Here is another way to visualize long call moneyness as it would appear on a stock chart.
Again, notice that the underlying security must be above the break-even point for an ITM money option to be profitable.
For a put option, the reverse is true – the option will be in-the-money if the strike price is above the current value of the stock trading in the market.
In this example, we now have a $100 strike put option.
The option is ITM if the stock price is lower than $100 because you can sell the stock for $100 when it is trading at $90 ($10 of intrinsic value).
So, the y-axis shows that the option contract moves toward profitability as the stock price falls below $100, and a loss when the stock price is above $100.
To explain OTM options, we simply reverse the ITM logic.
In this example, we have a $100 strike call option.
The option is OTM if the stock price is lower than $100 because you can buy the stock for $100. But why would you if it’s trading for less than that?
So, for a long call option, the option is out-of-the-money if the strike price is above the current value of the stock trading in the market. A long option position will have the max loss if the contract expires out-of-the-money.
Again, for a long put option, it’s the opposite. The option would be out-of-the-money if the strike price is below the current value of the stock trading in the market.
In this example, we again have a $100 strike put option.
The option is OTM if the stock price is higher than $100 because your put option only entitles you to sell the stock for $100. But if it’s trading at $110, why would you use the option? You wouldn’t. So the option is OTM.
Options are said to be ATM when the strike price and the stock price are the same so this applies to both long calls and long puts. Notice that ATM long options will still lose money at expiration because of the options's cost.
For example, if you buy a $100 long call for $5.00, the underlying stock price would need to be above $105 to make money. Even if the stock is closes at your $100 strike price on expiration, you will have a $500 loss. This is why it's so important to understand moneyness.
It is rare to have options with the same strike price as the stock price, so most options traders consider anything within a couple of points to be ATM. It’s essentially the “tipping point” between an option being OTM and ITM.
How should moneyness play into my trading strategy?
When options are ITM, they represent profitable opportunities for traders.
For example, buying a call option that is significantly ITM presents the same profit opportunity in terms of dollars as purchasing the actual stock, but you can trade with much less capital investment. This can result in a higher return.
Selling deep ITM options presents an opportunity to take profit immediately. Plus, there will still be remaining extrinsic value. Remember, the more time until expiration, the more value an option contract has.