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01-04-2012, 02:29 PM   #1

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Moneyness

Moneyness is the real value of an option. Investors calculate an option's trading price by adding its intrinsic value to its time decay value. To determine if an option is in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM), a trader must compare the underlying asset's market price to the option's strike price.

Intrinsic value
This value is simply the difference between the market price and the strike price. A call's strike price that exceeds its market price has no intrinsic value.

Example:
1) Underlying asset: GE currently trading at \$20
a) Call Option 1: GEA18, strike price at \$18 has an intrinsic value of \$2 (\$20-\$18)
b) Call Option 2: GEA22, strike price at \$22 has -(\$2) or \$0 intrinsic value (\$20-\$22)

Time Value
Simply put, options are a dying asset, meaning that its value slowly decreases starting from the moment it enters the market. Trading experts call this occurrence time decay. The closer a \$0 intrinsic value option gets to its expiration date, the less it is worth. Investors calculate time value by subtracting the option's trading price from its intrinsic value. Time value is equal to an option's price when it has no intrinsic value.

Example:
1) Underlying asset: GE currently trading at \$20
a) Call Option 1: GEA18 trading at \$3.50, strike price at \$18

Result: This option has an intrinsic value of \$2 and a time value \$1.50 (\$3.50-\$2.00). Its premium cost is \$3.50.

b) Call Option 2: GEA22 trading at \$.75, strike price at \$22

Result: This option has an intrinsic value of \$0 and time value \$.75 (\$0.75-\$0). Its premium cost is \$.75.

In-the-Money
To determine the moneyness of call and put options, a trader must look at their intrinsic values. ITM options are more expensive then ATMs and OTMs because of their positive intrinsic values. Finding out if a call or put option is ITM is easy, once a trader learns how to calculate the difference between the two.

ITM Call Options
If a call option's strike price is lower than the underlying asset's market price, then the call option is ITM. This means that call options with intrinsic values of \$.01 or more are ITM.

Example:
Underlying asset: GE currently trading at \$20
Call Option ITM: GEA18, strike price at \$18 has an intrinsic value of \$2

ITM Put Options
If a put option's strike price is higher than the underlying asset's market price, then the put option is ITM. This means that put options with intrinsic values of -(\$.01) or less are ITM.

Example:
Underlying asset: GE currently trading at \$20
Put Option ITM: GEA22, strike price at \$22 has an intrinsic value of -(\$2)

Out-of-the-Money
Out-of-the-Money options have no intrinsic value. Their values only reflect time decay, and they lose value as they get closer to the option's expiration date. The farther an OTM option deviates from the underlying asset's market price, the less it is worth. OTM options carry a high risk of expiring worthless.

OTM Call Options
If a call option's strike price is higher than the underlying asset's market price, then the call option is OTM. This means that call options with intrinsic values of -(\$.01) or less are OTM.

Example:
Underlying asset: GE currently trading at \$20
Call Option OTM: GEA22, strike price at \$22 has an intrinsic value of -(\$2)

OTM Put Options
If a put option's strike price is lower than the underlying asset's market price, then the put option is OTM. This means that call options with intrinsic values of -(\$.01) or less are OTM.

Example:
Underlying asset: GE currently trading at \$20
Put Option OTM: GEA18, strike price at \$18 has an intrinsic value of \$2

At-the-Money
Rarely does an option have the same underlying asset price as its strike price. When this happens, the option is ATM for both calls and puts. ATMs, like OTMs, only have time decay value, with an intrinsic value at exactly \$0.00.

Example:
Underlying asset: GE currently trading at \$20
Call Option OTM: GEA20, strike price at \$20 has an intrinsic value of \$0

NEXT: Options Expiration

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