In the money, at the money and out of the money refer to moneyness, an aspect of options trading that has important implications. This article covers the basic concepts of option valuation, which is critical in understanding moneyness.
Elements Of Option Pricing
A typical option quote contains the following information:
- Name of the underlying asset - i.e. shares or contracts
- Expiration date - i.e. December
- Strike price - i.e. 400
- Class - i.e. 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 Essential Options Trading Guide.)
Intrinsic Value And Time Value
The option premium is broken down into two components: intrinsic value and speculative or time value. The intrinsic value is an easy calculation - the market price of an option minus the strike price - representing the profit the holder of the option would book 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.
For example, let's say it's September and Pat is long (owns) a December 400 call option for ABC. 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 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 she would receive $8 more per share than by taking delivery and selling the shares in the open market.
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 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. 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, and the intrinsic value of both would 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 may still have time value.
The Importance Of Time Value
Time value is the main reason there is little exercising of options 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
(For more information see The Importance Of Time Value In Options Trading.)
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.