Moneyness: Definition, Examples, and Strategies

The significance of moneyness in options trading

Options trading is a complex financial strategy that involves various factors affecting the potential return on investment. Moneyness is one such crucial factor, and it can be a game-changer for options traders.

Defining moneyness

Moneyness is a term used to describe the intrinsic value of an option in its current state. It revolves around the relationship between the option’s strike price and the price of the underlying asset. In simpler terms, it tells us whether an option would be profitable if exercised immediately. Let’s break down the types of moneyness:

In the money (ITM)

An option is considered “in the money” when exercising it would result in a profit. For call options, this means the market price of the underlying asset is higher than the call’s strike price. Conversely, for put options, the market price should be lower than the strike price to be in the money.

For example, if you have a call option to buy shares of a company at $40, and the current market price is $45, your option is in the money. You can exercise it and buy shares at a discount.

At the money (ATM)

When an option is “at the money,” it implies that exercising the option would neither result in a profit nor a loss. This occurs when the market price of the underlying asset equals the option’s strike price. ATM options have both intrinsic and time value, making them a unique case.

Out of the money (OTM)

Conversely, an option is considered “out of the money” when exercising it would lead to a loss. For call options, this happens when the market price is below the strike price. For put options, it occurs when the market price is above the strike price.

For instance, if you hold a call option with a strike price of $50, but the current market price is $45, your option is out of the money. Exercising it would mean paying more for shares than their current market price.

Understanding intrinsic and time value

Moneyness primarily concerns the intrinsic value of an option. Intrinsic value is the financial benefit you would gain by exercising the option today. For call options, it’s calculated as:

Intrinsic Value of a Call = Market Price – Strike Price

For put options:

Intrinsic Value of a Put = Strike Price – Market Price

This value can be multiplied by the number of shares in the options contract, which is typically 100.

Aside from intrinsic value, options also have time value. Time value is the other determinant of an option’s value, and it’s linked to the remaining time until the option’s expiration date. The more time there is until expiration, the greater the potential for intrinsic value to increase.

However, as an option approaches its expiration date, time value diminishes and eventually becomes zero.

Why understanding moneyness matters

Understanding moneyness is paramount for options traders due to its profound impact on the value and profitability of options. Here are some key reasons why moneyness is crucial:

1. Determining option value

Half of an options contract’s value is attributed to moneyness. It enables traders to assess how much of the option’s price is associated with its intrinsic value, helping them make informed decisions.

2. Predicting profit potential

By grasping moneyness, traders can quickly gauge the profit potential of an options trade. If they anticipate a rise in the underlying asset’s price, they can strategically choose in-the-money or out-of-the-money options to maximize their gains.

3. Risk management

Understanding moneyness is essential for risk management. Complex options strategies often rely on moneyness to assess the level of risk associated with a trade. Traders can make more informed choices based on their risk tolerance and objectives.

Examples of moneyness in options

Let’s explore some real-world examples to solidify our understanding of moneyness in options:

Example 1: Call option

Imagine you hold a call option for Company ABC with a strike price of $50, and the current market price of Company ABC’s stock is $55. In this case, your call option is in the money (ITM). You have the right to buy shares at $50 when they are currently trading at $55, which could lead to a profit. This example illustrates an in-the-money call option.

Example 2: Put option

If you have a put option for Company XYZ with a strike price of $30, and the current market price of Company XYZ’s stock is $25, your put option is in the money (ITM). You can sell shares at $30 when their market price is only $25, potentially resulting in a profit. This showcases an in-the-money put option.

Example 3: At-the-money option

An at-the-money (ATM) option occurs when the strike price matches the current market price of the underlying asset. Suppose you have a call option for Company XYZ with a strike price of $40, and the stock is trading at exactly $40. This is an example of an at-the-money call option, where exercising it neither results in a profit nor a loss.

Example 4: Out-of-the-money option

Consider a call option for Company ABC with a strike price of $60, but the stock’s market price is $55. Your call option is out of the money (OTM) because exercising it would lead to a loss. You’d pay more for shares by exercising the option than by purchasing them at the current market price. This illustrates an out-of-the-money call option.

Advanced strategies utilizing moneyness

Experienced options traders often employ advanced strategies that take advantage of moneyness to achieve specific objectives. Here are two such strategies:

1. Covered call writing

Covered call writing is a strategy that involves holding a long position in an underlying asset while simultaneously selling a call option on the same asset. Traders typically sell out-of-the-money call options to generate income while holding the underlying asset for potential capital appreciation. This strategy exploits the moneyness of the call option to generate additional returns while capping potential gains if the option is exercised.

2. Bull put spread

The bull put spread is a credit spread strategy that involves selling an out-of-the-money put option while simultaneously buying a put option with a lower strike price, also out of the money. This strategy leverages moneyness to generate a net credit and profit if the underlying asset’s price remains above the sold put’s strike price. It’s a risk-limited strategy that benefits from a specific range of moneyness to achieve its maximum gain.

The bottom line

Understanding moneyness is fundamental to comprehending the intrinsic value of options, which is a key component in calculating an options contract’s worth. Whether you are a novice or experienced options trader, moneyness is a concept that should be firmly grasped to make informed and profitable trading decisions.

Frequently asked questions

What are the main factors that determine an option’s moneyness?

The primary factors influencing an option’s moneyness are its strike price and the current market price of the underlying asset. If the strike price is favorable in relation to the market price, it determines whether the option is in the money (ITM), at the money (ATM), or out of the money (OTM).

How can options traders use moneyness to create effective strategies?

Options traders can strategically employ moneyness to create effective trading strategies. By analyzing moneyness, they can make decisions on whether to buy in-the-money options for potential profits or out-of-the-money options for cost efficiency. Moneyness also plays a crucial role in constructing advanced strategies like covered call writing and bull put spreads.

What happens if an option’s moneyness changes over time?

An option’s moneyness can change as the market price of the underlying asset fluctuates. If an option moves from out of the money (OTM) to in the money (ITM), its value increases. Conversely, shifting from in the money (ITM) to out of the money (OTM) can decrease the option’s value. Traders need to monitor these changes to make informed decisions.

How do moneyness and volatility relate to each other in options trading?

Moneyness and volatility are interconnected in options trading. High volatility can impact an option’s moneyness by causing rapid price movements in the underlying asset. This can shift options between ITM and OTM positions. Traders should consider both factors when constructing their options strategies to manage risk effectively.

Are there specific industries or market conditions where moneyness plays a more significant role?

Moneyness is a fundamental concept across various industries and market conditions in options trading. Its significance remains consistent, regardless of the sector or market environment. However, during periods of extreme market volatility, moneyness becomes particularly crucial as options may rapidly transition between different moneyness categories.

How can options traders use moneyness to mitigate potential losses?

Options traders can use moneyness to manage and mitigate potential losses by selecting the appropriate moneyness category for their strategies. If a trader expects limited price movement in the underlying asset, they might opt for at-the-money (ATM) options. If they anticipate significant price changes, they could choose in-the-money (ITM) or out-of-the-money (OTM) options to tailor their risk exposure according to market conditions.