In the derivatives market, the relationship between the price of the underlying asset and the strike price of the contract has important implications. This relationship is an important determinant of the value of the contract and, as expiration approaches, will be a deciding factor when considering whether the options contract should be exercised.
The term moneyness describes how far away the underlying security's price is from the option contract's strike price. The contract can be in the money, at the money, or out of the money. An in-the-money option has intrinsic value, which means that there can be value extracted by exercising the contract. Out-of-the-money and at-the-money options have zero intrinsic value.
- The relationship between the stock price and the strike price of the option has an important bearing on the value of the contract and whether or not it should be exercised.
- Moneyness describes the relationship between the strike price and the stock price.
- When the stock price moves to the strike price, the contract is at the money.
- At the money options have strike prices equal to the stock price.
- There is typically no reason to exercise an at-the-money option because it has no intrinsic value.
For example, if the stock is trading $51 and the strike price of a call option is $50, the investor can exercise the call, buy the stock for $50, sell it in the market at $51, and extract $1 of intrinsic value. The value of the contract that is not intrinsic value, is called extrinsic or time value. So, if the 50-strike call is trading $1.50 with the stock at $51, it has $1 of intrinsic value and 50 cents of time value.
What Happens When the Strike Price Is Reached?
For call options, intrinsic value is the difference between the underlying stock's price and the option contract's strike price. For put options, it is the difference between the option contract's strike price and the underlying stock's price.
In the case of both call and put options, if the respective differences between the option strike price and stock price value are negative (the contracts are out of the money), the intrinsic value is zero.
In addition, when the underlying stock's price reaches the option contract's strike price, the stock option is said to be at the money. When a contract is at the money, the intrinsic value of the call and put option would be zero as well because, if you exercise the call option (or put option) contract and then sell (or buy) the underlying security, there is no gain or loss on the trade other than transaction costs.
Call vs. Put Options
Assume an investor buys one call option contract on stock ABC with a strike price of $50 in May and a July expiration. Further, let's suppose that it's the day that the option contract expires (or the third Friday of July). At open, the stock is trading at $49 and the call option is out of the money—it does not have any intrinsic value because the stock price is trading below the strike price. However, at the close of the trading day, the stock price sits at $50.
When the stock price equals the strike price, the option contract has zero intrinsic value and is at the money. Therefore, there is really no reason to exercise the contract when it can be bought in the market for the same price. The option contract is not exercised and expires worthless.
Exercising an option before expiration (which is not possible with some European-style options) results in the holder giving up and losing any remaining time value of the option.
On the other hand, assume another trader bought one put option contract on stock ABC with a strike price of $50 and a July expiration. On expiration day, if the stock is trading at $49 (below the strike price) in the morning, the option is in the money because it has $1 of intrinsic value of one dollar ($50 - $49).
However, let's say that the stock rallies and at the end of the trading day, it closes at $50. The option contract is at the money because the stock price is equal to the strike price and has zero intrinsic value. Therefore, the put option also expires without being exercised because exercising it does not monetize any value.