Options: Moneyness.



MONEYNESS.

As described in our last topic on strike price, ‘Moneyness’ explains the relationship between strike price of an option and the spot price of the underlying stock. There is a ‘gap’ or a difference between the strike price of an option and the spot price of the underlying stock. Moneyness trys to express the quality of that gap in terms of money value. I.e., whether the gap would result in a profit /loss for the option trader. So, Moneyness basically refers to the current state of the option in terms of profit and loss.

There are three degrees of Moneyness for an option –

  • In the money
  • Out of the money and
  • At the money

The expression ‘In the money’ means that the option, if exercised, would result in profits. For the holder of a call option, the strike price should be lower than the market price to be in-the-money. For the holder of a put option, the strike price should be greater than the market price to be in-the-money.

‘Out of the money’ means that the option if exercised would result in a loss. For the holder of a call, the strike price should be higher than the market price to be out-of–the-money. It’s just the reverse of what’s said above.

‘At the money’ means that the option and the underlying asset are at same price.

HOW EVERYTHING IS CONNECTED.

Option is a generally a zero sum game, assuming that one participant’s gains result only from another participant’s equivalent losses. This means that at contract expiry, the net change in wealth amoung the participants is zero. This has two implications-

1. Since calls and puts are opposites, what is in-the-money for a call holder will be out-of-the-money for a put holder and what is out-of–the-money for a call holder will be in-the-money for a put holder. This position will be reversed in the case of writers of calls and puts.

2. Since holders and writers are opposites, if the option is in–the-money for a holder, it is out-of-the-money for a writer. If the option is out-of-the-money for a holder, it is in-the-money for a writer. Obviously, if the option is at-the-money for the holder, it should be at-the-money for the writer as well.

Both the above positions are summarized below:

WHY IS MONEYNESS IMPORTANT?

  • A clear understanding about Moneyness is required to choose the correct option in a given situation.
  • This is one of the most frequently used option terminology and all the option trading strategies stem from Moneyness.
  • The knowledge of Moneyness will directly impact your decision making process in options.
  • Moneyness decides whether there is an intrinsic value for the option or not. In the case of options, intrinsic value is the money that you will receive when you exercise your options. Only in-the-money options have intrinsic value. For example, a call option has a strike price of Rs 100. The underlying stock is trading at Rs 150. In this case, the call option holder can exercise his right to buy at Rs 100 and sell at Rs 150 and make a profit of Rs 50. You can also say that the option has an intrinsic value of Rs 50. Out-of-the money options does not have any intrinsic value since by exercising such an option, there is no money to be made.

In simple terms,

  • An in-the-money option is in profits and has intrinsic value.
  • An out-of-the-money option is in loss and has no value.
  • If the option is in a no-profit no-loss situation, it’s at-the-money. These options too, does not have any value.
  • Calls and puts / holder and writers are inversely related. What’s in the money for one would be out-of-the-money for the other.
  • As the price of the stock changes, an option contract moves from one Moneyness state to another.
  • An option that’s very much in-the-money is also called ‘deep-in-the-money’ and an option that is very much out of the money is called ‘deep-out-of-the-money’.
  • Finally, no option, at expiry, will result in an exactly at-the-money position since costs are involved.

What are the costs involved? That’s what we will discuss in our next post on options.

You may like these posts:

  1. Options: Understanding strike price.
  2. Options: Kick off
  3. Types of derivatives 3 – Options contract

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