In short:
Moneyness is a general term used to reference the relationship between the price of an underlying asset and the strike price of an options contract.
Typically, moneyness for options contracts is broken down into three categories, in the money, at the money, and out of the money.
If an options contract has immediate exercisable value the option is said to be “in the money” (has intrinsic value). On the other hand, if the options contract doesn’t have immediate exercisable value the option is said to be “out of the money” (no intrinsic value). Lastly, if the price of the underlying asset and the options strike price are the same the option is “at the money” (no intrinsic value).
Key Points
- Moneyness is a general term used to reference the intrinsic value of an options contract.
- In-the-money (ITM) options have immediate value, the underlying assets price is higher.
- At-the-money (ATM) options are close to having immediate value but not quite since the price of the underlying asset and the strike price of the options contract are the same.
- Out-of-the-money (OTM) options are even further from having immediate value as the price of the underlying asset and strike price of the options contract diverge against the option owner.
In-depth:
How Options Get Their Value
From a high level, there are two portions of value that an option can contain, intrinsic value and extrinsic value.
An option contains intrinsic value if the option can immediately be executed to the benefit of the option owner. Keep in mind this doesn’t necessarily mean the option owner will profit. Rather, the difference between the underlying assets price and the options strike price benefits the option owner.
All options that haven’t expired contain some amount of extrinsic value or value that is not immediately tangible. Often, extrinsic value is primarily time value which is the amount of time remaining before the option expires. This represents a form of value to the option owner as there is still time for the option to gain intrinsic value or tangible executable value.
Ultimately, the combination of intrinsic and extrinsic value will factor in to determine the acceptable price of the option to both the seller and buyer.
So how does this relate to moneyness?
An options moneyness will be determined by whether the option is in the money, at the money, or out of the money. Or another way to put it is that an options price will be a reflection of the options moneyness.
In-The-Money (ITM) Options
“In the money” (ITM) is a term used to refer to an option where the underlying asset’s price justifies the execution of the options contract. In other words, ITM options contracts have a dollar gain to be realized between their strike price and the asset’s current market price.
- For a call option to be in-the-money, the underlying assets price must be higher than the options strike price.
- For a put option to be in-the-money, the underlying assets price must be lower than the options strike price.
When an option is in the money, it is said to have intrinsic value. It should be noted, however, that just because an options contract is in the money does not mean that the options contract will be profitable for the option holder. To be profitable, the option must be in the money far enough to produce a gain large enough to pay for the options premium and any brokerage commissions.
At-The-Money (ATM) Options
At the money (ATM) is a term used to refer to options where the price of the underlying asset is at or very near the strike price of the option. This is one of the three terms to describe the moneyness of options contracts, or where the price of the underlying asset is with respect to the strike price.
Despite being very close to being able to be exercised, ATM options have no intrinsic value. Instead, ATM options are often used when a trader expects a large price movement in the underlying asset.
Out-Of-The-Money (OTM) Options
Out-of-the-money (OTM) refers to an options contract where the difference between the strike price and the price of the underlying asset does not benefit the owner of the option.
- For a call option to be out-of-the-money, the underlying assets price must be lower than the options strike price.
- For a put option to be out-of-the-money, the underlying assets price must be higher than the options strike price.
For example, say we are looking at a Microsoft (MSFT) 295 call option and the current price of MSFT is $289/share, this option would be deemed to be OTM. This is because the strike price of the call option is significantly above the price of the underlying asset (MSFT stock).
What makes the option OTM is that the MSFT call option is not in a position to be profitable as it has no intrinsic value. Since a call option gives the buyer the right but not the obligation to buy the underlying stock at the strike price, with the strike higher than the underlying price there is no gain to be had by exercising the option.
The only value of an OTM option is the value of the time remaining before the options contract expires. The more time until expiration, the more valuable the option as there is more time for the option to end up ITM.
Additionally, the further OTM an option is the less valuable it is as it is less likely to end up ITM.
Investors may buy OTM for a variety of different reasons including hedging and speculation. If an investor is looking to speculate with OTM options, they are likely betting on a low probability/low cost but high return strategy. That way, if they are wrong, they only lose a small amount but if they are right they win by a lot.
For hedging, an investor with either a short or long position may elect to use OTM options to reduce the risk of large losses on positions they feel have a possibility to move radically against them. By using an OTM option, the investor can define the maximum amount they could lose for a much lower price than by using an ATM or ITM option.