When you trade options, you need to understand certain terms to know if your investment is worth it. One of the most important terms is option moneyness.
This simply tells you if an option has any real value compared to the price of the underlying asset. Understanding moneyness can help you make better trading decisions.
Options are different from stocks because they have an expiration date, meaning they lose value over time.
The price of an option depends on two things: its intrinsic value and time value. Moneyness helps traders figure out if an option is profitable based on how close its price is to the current market price of the underlying asset.
What is Moneyness?
Moneyness tells you whether exercising an option (buying or selling the asset at the strike price) will make you money. There are three main types of moneyness:
- In-the-money (ITM): The option has intrinsic value and would be profitable if exercised.
- At-the-money (ATM): The option’s strike price is exactly the same as the current market price of the asset, so it has no intrinsic value.
- Out-of-the-money (OTM): The option has no intrinsic value and would not make any profit if exercised.
Intrinsic Value
Intrinsic value is the actual profit you would make if you exercised the option right now. It is always zero or positive.
For example, if a stock is priced at Rs. 80, and you have a call option to buy it at Rs. 70, your intrinsic value would be:
- Intrinsic Value = Spot Price − Strike Price
- Intrinsic Value = 80 − 70 = 10
In this case, you could make Rs. 10 by exercising the option (ignoring any premium you paid for the option).
Why is Moneyness Important?
Understanding moneyness is key in options trading for a few reasons:
- Value Breakdown: It helps you understand how much of an option’s price is real value (intrinsic value) and how much is time-based value (time value).
- Profit Potential: Knowing whether an option is in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM) helps you predict its profit potential. For example, if you expect a stock to rise, you might buy an OTM call option, hoping it will become ITM.
- Risk Management: By understanding moneyness, you can better assess the risks involved, especially when using complex options strategies.
Trading Decisions: The moneyness of an option influences how you choose to use it. Options that are ITM are often better for exercise, while OTM options can be more speculative but come with less risk in terms of premiums.
Breaking Down Moneyness
Moneyness helps traders decide whether or not an option is worth using based on how it relates to the current price of the asset. Here’s what each type means:
In-the-Money (ITM)
An option is ITM if it has intrinsic value and would give you a profit if you exercised it.
- Call Options: A call option is ITM if the current market price is higher than the strike price.
- Put Options: A put option is ITM if the strike price is higher than the current market price.
Example:
If the current price of a stock is Rs. 420 and you have a call option with a strike price of Rs. 400, your intrinsic value is Rs. 20 (Rs. 420 – Rs. 400). The premium you paid for the option will also include time value (any remaining value before expiration).
At-the-Money (ATM)
An option is ATM when the strike price matches the current market price of the asset. It has no intrinsic value, but it still has time value.
Example:
If a stock is priced at Rs. 400 and you have a call or put option with a strike price of Rs. 400, the option is ATM. Exercising it now would not make any profit, but it may still have value due to the remaining time until expiration.
Out-of-the-Money (OTM)
An option is OTM if it has no intrinsic value and would result in a loss if exercised.
- Call Options: A call option is OTM if the strike price is higher than the current market price.
- Put Options: A put option is OTM if the strike price is lower than the current market price.
Example:
If a stock is priced at Rs. 420 and you have a put option with a strike price of Rs. 400, this option is OTM because exercising it would result in a loss. It’s unlikely you would exercise this option, but you might hope the price drops before expiration.
Making Informed Decisions with Moneyness
Knowing the moneyness of an option helps you make better trading decisions based on your investment goals and risk tolerance.
- Market Conditions: If you expect the market to rise, you may buy an OTM call option. If you expect it to fall, you might consider an OTM put option.
- Time Decay: Options lose time value as expiration approaches. If an option is ATM or OTM, its time value might decline quickly.
- Premiums: ITM options tend to have higher premiums, while OTM options are cheaper but riskier.
Understanding moneyness is essential for making smart trading decisions. By knowing how ITM, ATM, and OTM options work, you can better evaluate potential profits, risks, and align your strategies with market conditions.
Key Takeaways
- Moneyness indicates whether an option is profitable based on the current price of the underlying asset.
- ITM (In-the-money) options have intrinsic value and are profitable to exercise.
- ATM (At-the-money) options have no intrinsic value but may still have time value.
- OTM (Out-of-the-money) options have no intrinsic value and are less likely to be profitable.
- Intrinsic value shows the immediate profit potential of an option.
- Premiums for ITM options are typically higher because of the intrinsic value, while OTM options are cheaper but more speculative.
