Options are classified into three different categories based on the relationship of the strike price to the underlying stock price. These are ITM (in-the-money), OTM (out-of-the-money), and ATM (at-the-money) options.
This is known as option moneyness. We'll explore the three categories in this video lesson.
In this video, we're going to talk about option moneyness or the difference between in the money, out of the money and at the money options. We're also going to talk a little bit about extrinsic versus intrinsic value.
Options are classified by traders into three very distinct categories, in the money options, ITM, at the money options, ATM and out of the money options, or OTM. These are also used to quickly reference difference options when building complex options strategies.
You'll often see, especially in our ultimate strategy guide and in all of the different video tutorials and modules we have at Option Alpha that we will more often than not reference buying an in the money option and selling an out of the money or buying an at the money, selling at the money or whatever the case is.
We use these a lot as traders to quickly talk about a section or a group of trades based on where they are in the option pricing table. Let's go through an example here with a simple call option. This is a call options pay off diagram, probably one you've seen before on this track as we've been doing other videos.
For call options, there's a lot of different moneyness related to where the stock price is because again, everything in moneyness is determined based on the strike price and its relationship to the stock price.
In this case, if we have a 40 strike call option, that's where the payoff diagram pivots, this is a 40 strike call option. The option would be in the money is the stock price was higher than the strike price. If the strike price or if the stock price were higher than the strike price, then this option would be on the money.
In this case, if the stock price was $50 and we had the 40 strike options, we would be in the money. When I always think of in the money versus out of the money, in the money means am I making money or am I not, right?
That's the way I always distinguish it is if I'm in the money, I'm making money, meaning the stock price is higher than my strike price. For an option that is at the money, then the stock price is going to be equal to or very similar to the strike price.
An at the money option in this example would be a 40 strike call when the stock is trading at $40 or something very, very close to 40. An out of the money option would be when the stock price is dramatically below the option strike price.
Again, these are just for a call option. In this case, this would be when the stock price is at $30, and we are buying an out of the money 40 strike call where the strike price is above the current stock price. Again, the way I always think about it is an out of the money because I'm not making money yet.
My option isn't in the money at expiration. It's not making money yet. Another quick way to look at it is visually on a chart. In this case, if we have the current stock price at let's say $45 which is the difference here in these shaded areas.
If we see the stock trading from 45 down to 40, okay, then that strike price is in the money because the strike price down here at 40 with the stock trading at 45 means that we've got a $5 difference between our strike price and where the stock is trading at $45.
That strike price at 40 is on the money. It's making money right now. We can buy the stock at 40 and sell it back at 45. If later on, we look at a strike price of $45 which is exactly where the stock is trading right now and exactly where the strike price is, that strike price is at the money.
It's the strike price exactly where the stock is trading right at the moment. A strike price that's out of the money would be an example of a strike price around $50. Again, using the same numbers that we used before.
If the stock is currently trading at 45 and we buy a 50 strike call option, then that strike is out of the money. It's above where the market is trading currently. We need the stock to rally before we make any money at expiration.
All right, so let's flip things over here and look at an example with a put option. Now a put option is going to be pretty much everything just in reverse. A put option that's in the money, meaning they're making money, is when the stock price is now below where the strike price is.
In this case, if we have the 40 strike put options, we'd be in the money if the current stock price was $30 and if we had the 40 strike put options, those would be in the money because they'd be making money based on the current stock price of $30.
If we had an at the money put option, obviously the strike price and the stock price would be very similar or the same. This would be a $40 strike price and a $40 stock price. If we had an out of the money put option, that means that the stock price is much higher than the current strike price.
If the current stock price was $50 and we wanted to trade the 40 strike puts, those 40 strike put options would be out of the money or below where the stock is trading right now. Okay?
Here's the thing, before we get into some examples of my live thinkers from the platform, pricing for options is put into two components. There's two main components that make up pricing. There's intrinsic value, and then there's extrinsic or time value for an option contract.
I'm going to show you how we can see the differences between those for every contract that you want to look at. It's important to realize that an option with intrinsic value is in the money and does have value at expiration.
That's how we determine intrinsic value is we ask ourselves if expiration was today could you make money on this option? If the answer is yes, then it's an in the money option. If the answer is no, then it's an out of the money option and usually at the money options are either just slightly in or just slightly out of the money. Okay?
Let's look again at a couple of examples here. We're going to go back to our option pricing table here with DIA. We've used this one in a couple of other videos inside of this beginner track here at Option Alpha.
Again, just to refresh your memory, we've got all of the strike prices right down here in the middle and then we've got the call options on the left-hand side, and we've got the put options on the right-hand side.
Now I've adjusted these actual columns to show you intrinsic and extrinsic value because this is going to help us understand which options are in the money and which options are out of the money. Now the first thing we have to realize is that DIA right now is trading at 176.07.
Now this is going to move because this is all live, real-time pricing. It's trading at 176.0708, so a couple of pennies above 176. Let's start on the call side of the options pricing table. Now it's cool here because Think Or Swim does a really good job, and most broker platforms do, they usually shade any call options that are on the money.
They might shade them a different color, but you can see that really with a call option any strike price that is below where the current stock price is is going to have an option that is in the money on the call side.
Now you can see all of these options, 174s, then 174.5, 175, et cetera, et cetera. These are all in the money right now on the call side because the options strike price is below where the current stock price is.
You'll notice that the 176.5 call options are not shaded here, and that is because those options are just slightly out of the money. Those options are just slightly out of the money. The at the money options, in this case, would be the 176s because they are the closest to where the stock is trading right now.
Again, it will never be exactly perfect. You'll probably rarely see a stock trade right out at round number all the time, but it's always going to be the strike prices that are closest to where the stock is trading currently. In our case with DIA, it's the 176 calls inputs. That's the at the money strike.
Now again, on the call side, the out of the money options are the ones that are not shaded. These are the ones withstrike prices that are higher than where the stock is currently trading right now. DIA is trading at 176. All of these strike prices are above or higher than 176.
That means that all of these options are OTM or out of the money. If we ever talk about selling at out of the money or buying an out of the money, we're talking about these options on the left-hand side.
If we use the put side now and go over to the other side of the pricing table you can see everything is now in reverse because put options and call options basically trade in reverse, meaning that everything with a strike price now above where the stock is trading are options on the put side that are on the money.
They're all shaded yellow here. These are all in the money options. You'll notice now the 76 option on the put side is out of the money versus being just slightly in the money on the call side. Now you can see that that's the difference.
Again, these, this shading will change as the value and as the price of the underlying stock changes. As it goes up and as it goes down most broker platforms will show you the difference between these.
Again, these options over here, these are all in the money, ITM. These options down here, these are all out of the money, or OTM on the put side and visa verse on the call side. Now in both of these categories, we have these extrinsic and intrinsic value.
Now remember what we said about intrinsic value. The intrinsic value would be the value if expiration were to come today, meaning how much money could you make owning these options if expiration came today and you had no choice but to buy and sell the stock as required by the option contract?
In this case, you look at something like the 176 call options, and you can see that the intrinsic value is the difference between the current stock price and the strike price, that's 176. The current stock price is 176.13.
If the market were to end today and expiration were to come today, we could theoretically buy the stock at 176, sell it back at 176.12 or 176.13, and that's where we come up with our intrinsic value of 12 cents for this contract.
Again, this is going to move. Intrinsic value is always going to move penny for penny with where the stock is, and it's going to show you how much money you could make at expiration if everything were to end today. Okay? Now notice any out of the money options have no intrinsic value.
That means you would never exercise your contract to buy a 176.5 stock and then be able to sell it for 176.11. You would never buy stock willingly for more than you could sell it for at the same time.
That's why you'll see all out of the money options on both sides have zero intrinsic value. There's no value to those at expiration. That's why they expire worthless at expiration because eventually the value of options always goes towards intrinsic value.
That's what happens. They always go towards intrinsic value as they near expiration. Now extrinsic value is a combination of time decay and volatility and a little bit of dividend and interest rate pricing for options. Extrinsic value shows you the additional value of that contract based on how much time is left and how much volatility is in the market.
This is where we start to talk about our edge in trading because extrinsic value can fluctuate very, very fast without the stock moving. As implied volatility rises extrinsic value across the board rises as well.
All option values rise when implied volatility rises. Just like all option values drop when implied volatility drops. The stock does not have to move. In this case, it's showing you that let's take the 176.5 call options here.
Those options right now are priced between 185 and 190, but all of that value of those options is extrinsic value, meaning all of the value of those contracts right now is based on the assumption that there are time and volatility that those contracts may at some point in the future increase in value of some intrinsic value. Okay?
You'll notice that as you go further and further out of the money the value of options goes down because there's a low likelihood that those options become in the money. Right? The options that are close like the 176.5, those options have a pretty good shot of being in the money, meaning there's a pretty good shot that that DIA trades from 176.15 up to and above 176.5.
There's less likelihood that it trades up to 179. The value of those options in their extrinsic value format is much, much lower than the 176.5 because there's a lower likelihood that DIA trades up to 179. Okay?
This concept of intrinsic and extrinsic value is very, very important, especially as we talk about how options are priced, how prices move and how prices fluctuate with different changes in the market and now we're starting to develop hopefully a good solid foundation as we move further into track one and kind of towards the back half of track one in talking about option strategies, how to choose those and options pricing and why our edge is mainly surrounded by implied volatility.
Again, thank you so much for checking out this video tutorial. If you have any comments or feedback, please ask them in the comment section right below. If you love this video and you want other people to see it, please share it online. Help spread the word about what we're trying to do here at Option Alpha. Until next time, happy trading.