The Concept of Option Moneyness
Moneyness, which may sound like a strange word, is a character or state of an option which tells us something about its intrinsic value and the relationship between the option’s strike price and current market price of the underlying stock.
Every option is one of these three cases of moneyness:
- In the money
- At the money
- Out of the money
In option talk these three states are often referred to under acronyms ITM, ATM, OTM. When describing an option strategy, you often hear statements like “buy an ITM call”, “sell an OTM put” etc.
To decide whether an option is ITM, ATM, or OTM, you need to know its strike price, the current underlying price, and also the type of the option, because moneyness is different for calls and puts.
Call Option Moneyness
A call option is:
- In the money if its strike price is below underlying price
- At the money if its strike price is equal to underlying price
- Out of the money if its strike price is above underlying price
Generally, low strike calls are in the money, while high strike calls are out of the money. Calls represent rights to buy the underlying, and you want to buy as low as possible. Therefore, low strike calls are good (in the money), while high strike calls are less valuable.
Put Option Moneyness
It is exactly the opposite with put options, because puts represent rights to sell, and you want to sell as high as possible.
A put option is:
- In the money if its strike price is above underlying price
- At the money if its strike price is same as underlying price
- Out of the money if its strike price is below underlying price
Low strike puts are out of the money, while high strike puts, which when exercised allow you to sell the underlying above the current market price, are in the money.
Characteristics of ITM, ATM, and OTM Options
Each of the three states of moneyness has some common characteristics.
At the money options tend to have greatest time value. They also tend to be among the most actively traded (most liquid).
In the money options are generally more expensive than at the money or out of the money options, because they have intrinsic value. Option premium of ITM options has two components – intrinsic value and time value. Option premium of ATM and OTM options is equal to time value, because their intrinsic value is zero (see note about ATM options below).
In the money options are also most sensitive to changes in underlying price – in Greek talk, they have high positive (calls) or high negative (puts) delta. Out of the money call and put options have delta close to zero. At the money options are something in between.
A Note about ATM Options
In practice, at the money options don’t need to have strike price exactly equal to underlying price. It is quite common to refer to the strike price that is closest to current underlying price as “at the money”, even when it is not exactly equal. For instance, if underlying price is $74.67 and available strikes are $65, $70, $75, $80, $85, the $75 strike call and the $75 strike put would be considered at the money.
As a result, some options may be considered at the money and have non-zero (though very small) intrinsic value. The $75 strike put in the above example has intrinsic value of $0.33 per share.
Deep ITM and Far OTM
The above being said, option moneyness is not really just three states – it is more like a continuous scale. In other words, all ITM options (or all OTM options) are not equal. One in the money option can be more (“deeper”) in the money than another. One out of the money option can be more (further) out of the money than another, if its strike price is further away from the underlying price than the other option’s strike price.
The terms “deep in the money” and “far out of the money” are quite common when option traders describe the degree of moneyness.
What Moneyness Doesn’t Depend on
Option moneyness is determined only by the relationship between its strike price and the current market price of the underlying stock. Nothing else.
Moneyness and Option Premium
Option moneyness does not directly depend on option premium (market price of the option). In general, in the money options have higher premiums than at the money and out of the money options with the same expiration date on the same underlying, but option premium itself does not decide whether an option is in the money or out of the money.
For example, an option trading for $6.50 can be out of the money, while another option (perhaps on a different underlying or with different expiration date) trading for $0.30 can be in the money.
In another example, consider a call option with $50 strike. Let’s say the underlying stock is trading at $49 and the option is trading at $2.00, with 60 days left to expiration. The option is out of the money, because it is a call and its strike price is above current underlying price. One month later, with 30 days left to expiration, the stock is trading at $51 (the option is now in the money), but the option premium is only $1.77 – less than when the option was out of the money one month earlier. This is because an options moneyness and intrinsic value is only one of two components of option premium. The other is time value, which in our example was $2.00 with 60 days to expiration and only $0.77 with 30 days to expiration.
In sum, an option’s moneyness (or more precisely its intrinsic value) affects its premium, but option premium does not affect moneyness.
Moneyness and Profit or Loss
When talking about option moneyness, we are not considering initial cost of the option or total profit or loss from an option’s trade. In other words, an option being in or out of the money does not tell you whether you have made or lost money trading the option.
You can exercise an in the money option and still end up losing money if you have initially bought the option for more than what you gain from exercise. For example, you buy a $20 strike call option for $2. The underlying stock is trading at $21 close to expiration – the option is in the money by $1. You decide to exercise the option, get the stock for the $20 strike and immediately sell it in the stock market for $21. You gain $1 from the exercise, but overall, after your initial cost, you lose $1. An in the money option doesn’t mean automatic profit.
Conversely, you can sell an out of the money option and make a profit if you initially bought the option for less. You can even buy an option when it is out of the money and later sell it when it is out of the money, but has higher premium, therefore you make a profit from that trade. This is admittedly an unlikely case, which would require very short holding period and sharp increase in implied volatility that would offset the loss of intrinsic value.
In any case, option moneyness is not about you profit or loss from a trade. It does not depend on current option premium or your initial cost of buying the option. It should also be clear by now that moneyness also doesn’t depend on volatility or time to expiration.
Moneyness depends on the relationship between strike price and underlying price only.