You may have heard the terminology before: in the money, at the money, out of the money; but what does it all mean?

These terms all refer to one aspect of options trading - moneyness - and finding out what it means has important implications for options traders. This article attempts to cover the basic concepts of option valuation, so that you can move on to building your model with a better understanding of its vital foundation. (For more basic information, read Understand Option Pricing.)

Elements Of Option Pricing
An option quote usually contains the following information:

  • Name of underlying asset - ie. Google
  • Expiration date - ie. December
  • Strike price - ie. 400
  • Class - ie. 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 Options Basics tutorial.)

Intrinsic Value And Time Value
The option premium is broken down into two components: the intrinsic value and the speculative or time value. The intrinsic value is an easy calculation - the market price of an option minus the strike price - and it represents the profit that the holder of the option would enjoy 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 Google (Nasdaq:GOOG) December 400 call option. The option has a current premium of 28 and GOOG 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 then she would get $8 more per share than she would by taking delivery of the shares (calling them away) and selling them in the open market.

As an aside, 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 can, with a far lower capital investment. This translates into a much higher return on actual investment.
Selling deep-in-the-money covered calls presents a trader with the opportunity to take some of their profit immediately, as opposed to waiting until the underlying stock is sold. It also can be very profitable when a long stock appears to be overbought, as this would increase the intrinsic value and often the time value as well, due to the increase in volatility. (For more on this option strategy, read The Basics Of Covered Calls. For more on the importance of volatility in option trading, see our Option Volatility tutorial.)

Out-Of-The-Money Options
Returning to our example, if Pat were long a December 400 GOOG put option with a current premium of 5, and if GOOG 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 negative; the lowest it can ever be is zero.

At-The-Money Options
A third scenario would be if the current market price of GOOG 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 immediate exercise of either option would not result in any profit. However, that doesn't mean that the options have no value - they could still have time value. (For tips on more-advanced option-trading options, see our Option Spreads tutorial.)

The Importance Of Time Value
Time value is the main reason that there is very little exercising of options and a lot more closing out, offsetting, covering and selling of contracts. In our example above, 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 actual shares. The $8 covers the speculation that exists in regard to the price of GOOG between September and expiration in December.

The market determines this part of the premium; however, it is not just a random assessment. Many factors come into play in the establishment of the time value of an option. The Black-Scholes option pricing model, for example, 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

(For more information see The Importance Of Time Value.)

Conclusion
In summary, understanding the basics of valuing options can be said to be part science and part art. It is vital to understand where profits come from and what they are expected to represent, in order for option-trading profits to be maximized.

For discussion and evaluation of actual option pricing models, see our Employee Stock Options tutorial.

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