What Does Option Moneyness Mean ?

In the previous blog we learnt What is Option Trading ? .However that was just the basics ,as we know “half knowledge is the dangerous thing”. In this blog we will be learning another aspect of option’s trading knowns as “Option’s Moneyness”. This blog covers the basic concepts of options valuation. This is very critical in understanding moneyness. As a matter of fact it’s vital that anyone considering trading options should be familiar with it. So ,Let’s begin to dig deeper .

Moneyness in options can be define as the association between the strike price of an options contract and the price of the underlying security.The underlying price is the price at which the underlying asset trades in the spot market.This is current market price at which stock is trading in spot market .

There are three main classification that are used to describe the moneyness of an options contract.

  1. In the money (ITM)
  2. At the money (ATM)
  3. Out of the money (OTM

The purpose of this classification is to help trader to decide which strike to trade, in the market in a given scenario.Before we jump in to know about all these terms ,one should be aware of “Intrinsic Value”.

Example of an Option’s Intrinsic Value suppose you buy a call option at strike price of 30, and the underlying stock’s market price is Rs.38 per share. Than intrinsic value of the call option would be 8. Intrinsic Value of a Call option = Spot Price – Strike Price Rs.38 stock price minus 30 strike price (38-30). To put it differently the intrinsic value of an option is the money the option buyer would make from an options contract, If he has the right to excercise the options on a given day.

To understand this as an illustration we will be doing a little excercise.

Underlying Nifty50
Spot Value 11200
Option strike 11000
Option Type Call Option (CE)
Premium price 200
Position Long(buy)

 

Let us assume you bought Call Option for NIFTY50 @ 11000CE and instead of waiting till expiry you had the right to exercise the option today. It’s important to realize when you exercise a long option, the money you make is equal to the intrinsic value of an option minus(-) the premium paid. To answer the above question we will be calculating the intrinsic value of an option:

Formula to calculate –

Intrinsic Value of a Call option = Spot Price – Strike Price

= 11200 – 1100

= 100

So, if you were to exercise this option right now, you would be making Rs.100  .You need to subtract this from premium paid to get net P&L.

Likewise for Put Option formula to know Intrinsic Value(IV) = Strike Price – Spot Price

Now Assume, Spot Value = 11000 and Option strike = 11500 Than, IV= 11500-11000 = 500

Important Note :

Intrinsic value of an options contract can never be negative. It can be either positive number or Zero.

I know you might be thinking why IV is non-negative number?To understand this let’s go through another example, Strike price is at 500, spot price is 480, option type is long call & the premium is Rs.10.

  1. If you were to exercise this option,How much is the intrinsic value?  Intrinsic Value = 480 – 500 = -20 . Which means Rs.20 is going from out from our pocket . Now Let us assume this is true for a second, what will be the total loss? Adding premium paid with this value ,10 + 20 = Rs.30/-
  2. But on the contrary we know the maximum loss for a call option buyer is limited to the extent of premium one pays, in this case it will be Rs.10/-.
  3. This is termed as “non linear property of option payoff”, Hence in order to maintain this Intrinsic value can never be negative.
  4.  You can apply same arguement to the put option intrinsic value calculation as well.

This is the concept of Intrinsic value ,hope you have understood it compeletly now. Now let us discuss the main topic What Does Option Moneyness Mean ? To understand it better ,we will dicuss both topics of “Moneyness of a Call option & Put Option in isolation .

Call Option Moneyness :

As we have discussed earlier there are three main classification that are used to describe the moneyness of an options contract. Apart from that there are other two classification included in the list :

  1. Deep In the money
  2. In the Money (ITM)
  3. At the Money (ATM)
  4. Out of the Money (OTM)
  5. Deep Out of the Money

Points to keep in mind to Understand these option strike classification .

  1. First you need to calculate the intrinsic value.
  2. If the IV is a non zero number, then the option strike is considered ‘In the money’.
  3. If the intrinsic value is a zero(as IV can’t be -ve) the option strike is called ‘Out of the money’.
  4. The strike Price which is nearest to the Spot price is called ‘At the money’.

let’s first stick to these 3 major category ITM,ATM,OTM .Below is the Option chain of Nifty currently trading @11250 in spot market ,let discuss them one by one and understand it .

What Does Option Moneyness Mean ?
Light Yellow background reflects ITM options on the other hand all OTM options have a white background.

 

As you can see from the image above, the available strike prices ranges from from 10900 to 11850. This is not the full image of option chain ,taken few part for illustration purpose.

Let us first clear concept of ‘At the Money Option (ATM)’ . As described above

  1. The strike Price which is nearest to the Spot price is called ‘At the money’.
  2. It means current spot price which is 11250 nearest to that would be your At the money option ,check under blue line 11250 strike is available hence this would be your ATM Option.

How to identify In the Money (ITM) Call options

In order to understand this we will choose strike price & calculate it’s intrinsic value.Let’s say

  1. 11000
  2. 10900

Now spot price of Nifty is 11250, keeping this in reference we would be calculating the intrinsic value for the strikes mentioned above –

 11000

Intrinsic Value = 11200 – 11000 (Call option Intrinsic value = Spot Price – Strike Price)

= 200 We know that If the IV is a non zero number, then the option strike is considered ‘In the money’.

10900

Intrinsic Value = 11200 – 10900

= 300 As this is also Non zero value, hence the strike should be In the Money (ITM) option .

How to identify ‘Out of the money’ OTM Call Options 

If the intrinsic value is a zero(as IV can’t be -ve we understood that above) the option strike is called ‘Out of the money’. In order to understand this we will choose strike price & calculate it’s intrinsic value.Let’s say

11350

Intrinsic Value = 11250 – 11350

= – 100

Negative intrinsic value, however we consider it as 0. As the intrinsic value is 0, the strike is called as “Out of the Money” (OTM).

11500

Intrinsic Value = 11250 – 11500

= – 250

Negative intrinsic value, however we consider it as 0. As the intrinsic value is 0, the strike is called as “Out of the Money” (OTM).

So the generalization that you can withdraw from above examples for a call options would be .

  1. All option strikes above than the ATM strike are considered OTM .
  2. All option strikes which are below the ATM strike are considered ITM .
Deep In the money & Deep Out of the Money :

First thing to remember “Higher the intrinsic value, deeper the moneyness of the option” . For example : Assume Spot price of Nifty is @ 11250 and we choose strike price of 10600,

Intrinsic value = 11250 -10600 = 650

As compare to 10900 Strike whose Intrinsic value was 350 ,This as higher IV. Hence this strike of 10600 is considered as ‘Deep In the Money’ option and 10900 as just ‘In the money’ option.

In the same fashion Deep Out of the Money Works ,when the intrinsic value is the least, it is called Deep Out of the Money .Far the strike price from OTM (Out of the Money).

Put Option Moneyness :

Let us try to understand Moneyness in case of Put option contract .Let us find out how strikes are classified as ITM and OTM for Put options .

What Does Option Moneyness Mean ?
Light Yellow background reflects ITM options on the other hand all OTM options have a white background.

 

On Right hand side in green arrow mentioned all Put Options. LTP refers to latest trading price of premiums . In blue all strike price mentioned .

As you can see there are many strike prices available starting from 10900 to 11850. Considering the spot price of Nifty @ 11300 ,let us try to find out  ATM, ITM and OTM option. We have already learned the nearest strike to spot should be the ATM option.

As we can see from the image above there is a strike at 11300 ,which is by the way our spot price as well for nifty.We will consider this as At the money option (ATM) .The LTP for premium for put option is Rs.39.20 . In case if 11300 not available than the nearest strike like 11350 or 11250 can be counted.

How to identify In the Money (ITM) Put options :

In order to understand this we will choose strike price & calculate it’s intrinsic value (Moneyness). Let’s take

  1. 11400
  2. 11650

Intrinsic value of put option can be calculated as = Strike – Spot

Intrinsic Value = 11400 – 11300

= 100

Positive intrinsic value, therefore the option is ITM

How to identify ‘Out of the money’ (OTM) Put Options :

If the intrinsic value is a zero(as IV can’t be -ve we understood that above) the option strike is called ‘Out of the money’. In order to understand this we will choose strike price & calculate it’s intrinsic value. Let’s say

  1. 11200
  2. 11000

Intrinsic Value = 11200 – 11300

= –100

Negative intrinsic value, however we consider it as 0. As the intrinsic value is 0, the strike is called as “Out of the Money” (OTM).

Intrinsic Value =11000-11300

= -300

the strike is called as “Out of the Money” (OTM).

So the generalization that you can withdraw from above examples for a call options would be .

  1. All strikes which are Above ATM options are categorized as ITM .
  2. All strikes which are below ATM options would be considered as OTM .

Conclusion with Few Important Points :

To begin with , I would request you to have a look on the option chain image above .You can find the option chain details for any stock or index by visting NSE Website .Why is there difference in premiums value ? Its very important to realize the premiums for ITM options are higher than the premiums for the OTM options. In other words ITM options are always more costly as compared to OTM options. The premium keeps on decreasing as you travel from ‘Deep ITM’ options to ‘Deep OTM option’. 

What is the Purpose of Knowing Option Moneyness :

You might be thinking What is the purpose to know all this terms. As a matter of fact Even if you are just using very simple strategies like taking a single position, you still need to consider moneyness. Understand this every options trading strategy requires knowing what moneyness state the options you are buying or selling (writing).

For example, if you are buying contracts on an underlying security that you expect to move substanialy in price in a short time frame, then buying out of the money contracts would increase chances of your profits. On the contrary If you are expecting a smaller movement, then in the money contracts would probably works as a better &less risky .

In case you start using more complex strategies, moneyness becomes even more important. Another example,May be a strategy might involve buying in the money contracts and then writing out of the money contracts on the same underlying security. We will learn about the different option strategies in upcoming blogs . Till than clear your basic concepts and misconceptions about Derivative market . If you have any concern ,Questions releated to market you can put that in our comment section .Check out Asthatrade options and futures Margin calculator in case you need to know Margin requirement .

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