In-the-money, at-the-money and out-of-the-money are commonly used terms that refer to an option's moneyness, an insight into the intrinsic value of these derivatives contract.
This article covers the basic concepts of moneyness, which also bears on option valuation and trading.
- Moneyness describes the intrinsic value of an option's premium in the market.
- At-the-money (ATM) options have a strike price exactly equal to the current price of the underlying asset or stock.
- Out-of-the-money (OTM) options have no intrinsic value, only "time value", and occur when a call's strike is higher than the current market, or a put's strike is lower than the market.
- In-the-money (ITM) options have intrinsic value, meaning you can exercise the option immediately for a profit opportunity - i.e. if a call's strike is below the current market price or a put's strike is higher.
Overview: Elements Of Option Pricing
As a basic overview, let us consider a typical option quote that will contain the following information:
- Name of the underlying asset - i.e. ABC Corp. stock
- Expiration date - i.e. December 2020
- Strike price - i.e. 400.00
- Class - i.e. Call vs. Put
- Price - i.e. The option premium
The price of an options contract is known as 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.
These elements work together to help you 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.
Intrinsic Value And Time Value
The option premium can be theoretically broken down into two components:
The intrinsic value involves a straightforward calculation - simply subtract the market price from the strike price - representing the profit the holder of the option would book if they exercised the option, took delivery of the underlying asset, and sold it in the current marketplace.
The time value is then calculated by subtracting the intrinsic value of the option from the option premium.
Let's see how moneyness plays out. For example, let's say it's September and Pat is long (i.e. she owns) a December 400 call option for ABC Corp.. 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 (ITM) option is an option that has some 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. For a put option, which gives the holder the right to sell shares at a set price, intrinsic value would exist if the strike price is higher than the market price, allowing you to sell the shares for more than they are worth and buy them back lower.
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.
Returning to our example, if Pat was instead 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 (OTM). 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.
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 (ATM), and the intrinsic value of both would here 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 will still have time value.
The Importance Of Time Value
Time value is the main reason there is little exercising of options in practice 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:
- Price of the underlying asset
- Strike price of the option
- Standard deviation of the underlying asset
- Time to expiration
- 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.