This is the video tutorial for one of the bigger topics when it comes to options trading basics, and that’s option moneyness. We’re going to get right into it here. And options are classified by traders into three distinct categories.
We usually have them by their little acronyms, and that’s ITM which is in the money options, ATM which are at the money options and OTM which are out of the money options. Again, these are used to quickly reference different options when building complex strategies.
For example, if I was to email one of my members trying to help them out with a trade, I could email them and say, “John Smith, buy one at the money call and sell one in the money put,” whatever the case is. It just helps us quickly reference where options are located on a pricing table.
Let’s look at a call option as our base example here and then we’re going to look at a put option right after this. If you look at this call option here, you can see that we have a strike price of $40 and that’s where the option pivots.
When we look at our moneyness, you can see that in the money options are going to have a stock price that is less than the strike price. If the strike price is $40 and the stock price is $50, then that is going to be considered an in the money call.
An at the money call, the stock price is going to be equal to the strike price. If we have a strike price of $40 and the stock is also trading at $40, that means that our option is right for the money. It’s not on the money.
It’s not out of the money. It’s right on the market. It’s right on that edge of being on either the other categories. And then finally, we have an out of the money option, and in this case, the stock price is going to be lower than the strike price.
If we have a stock price of $30 and our strike price is $40, then that is clearly going to be very, very much out of the money call. The call hasn't even been close to the market price. The market has to rally considerably for that option to make money.
Flipping it around here, we’re going to look at a put option. Again, most of the things are similar, it’s just flipped around, so it’ll take you a little bit to understand it, but if you have an in the money put, you’re going to have a stock price which is less than the strike price.
Our 40 strike put here just flipped around, and the stock price is $30, that means that we’re going to be on the money about $10 because we can sell the stock at $40 and buy it back at $30.
An at the money option is going to be just the same for a put and a call. It’s going to be an option that is right for the money with the strike price and stock price being roughly equal, so right around $40.
And then an out of the money put is going to be a put where the stock price is higher than the strike. Again, remember we're dealing in puts here, so if the stock price is $50 up here and the strike price is $40, then we are out of the money by about $10 before we ever make any money at expiration.
Let’s use this visual example here really quickly just to see where at the money, in the money, etcetera are. If we have a strike price of $40 for example on this option, let’s say we have a call option with a strike price of $40 and the market is trading at $45, then our strike price is considered in the money.
It’s less than the market price for a call option. If we have a call option with a strike price at $45 and the stock is trading right at $45, then our strike price is at the money. It’s right at the market price.
And again, if we have a strike price of $50 and the stock is trading at $45, then our strike price is considered out of the money. It’s not making any money if we were to go to expiration right today.
Let's throw a little curve ball here. This is a spread. It’s a combination of two different option contracts that create this different diagram that we talked about. In this particular example, what you want to focus on here is just where the strategy makes money (here’s the zero profit loss line) at expiration.
That's really where you want to focus. Anything around $37 or so would be considered at the money for this particular contract, anything inside or below $37 would be on the money, and then anything above $37 would be out of the money because we lose money at expiration if it’s anywhere above $37.
That's the difference. When you're combining options, just make sure you take time and look at these profit loss diagrams. Remember that option moneyness and option premiums are determined by two major components.
We have intrinsic value or the value right now, and then we have extrinsic value or time value of the option. Those two things come together, and that creates the option premium or the total price.
Just remember that an option with intrinsic value is in the money and does have value at expiration, has value right now if it were to expire if it were to go to expiration today. And that's one of the ways that you can determine if an option is in the money, out of the money or at the money.
As always, I hope you guys enjoyed this video and learned a lot about option moneyness. If you want to share this video with any of your friends, colleagues or co-workers, just use the social media links right below this video and share it on your favorite social network.