Basics Of Options
Moneyness of Options
After discussing the concept of Call options and Put options, in this unit we will discuss the ‘Moneyness of Options.'
Moneyness is a term which describes the relationship between the spot price of the underlying asset and the strike price which is the pre-determined price and the premium.
A clear understanding about Moneyness is required to choose the correct option in a given situation. It is one of the most frequently used option terminologies and all the option trading strategies stem from Moneyness. This concept will directly impact our decision-making process in options.
Nifty Spot price is trading at ₹17200. And we are considering Nifty 17100 Call option. Now, suppose we assume that this option contract expires very next moment, so what is the minimum premium the seller is going to charge the buyer for this contract?
The seller of the contract is sure that this particular contract is going to get exercised, the buyer will exercise his contract as he will be able to buy NIFTY at 17100 where as currently its trading at 17200. So the loss which the seller will incur from the exercise of the option will be ₹100 (17200-17100).
This is the payoff from the call option. So, knowing that this contract expires next moment and it will be exercised, the minimum the seller should charge the buyer is ₹100 premium.
An option premium can be broken up into two – 'Intrinsic Value' of an Option premium and 'Time value' of an option premium.
Intrinsic Value of Options:
The intrinsic value of an option represents the current value of the option, how much worth it is. It’s the positive payoff for the Buyer. It represents what the buyer would receive if he decided to exercise the option right now. So, in accordance with our example it's ₹100.
The intrinsic value of an option is calculated differently depending on if it is a call option or a put option, but it always uses the strike price of the option and the price of the underlying asset.
For call options: Intrinsic Value = Max of (Price of Underlying Asset - Strike Price), 0
For put options: Intrinsic Value = Max of (Strike Price - Price of Underlying Asset), 0
Intrinsic value of options is never negative. It is either 0 or a positive number.
Time value of options:
The time value of an option is an additional extra amount a buyer is willing to pay over the current intrinsic value. Buyers of the options are willing to pay this because an option premium could increase in value before its expiration date. This means that if an option is months away from its expiration date, we can expect a higher time value on it because there is more opportunity for the option to increase or decrease in value over the next few months.
If an option is expiring today, we can expect its time value to be very little or nothing because there is little or no opportunity for the option to increase or decrease in value.
Time value is calculated by taking the difference between the option’s premium and the intrinsic value.
- Time Value = Option Premium - Intrinsic Value.
We can conclude by saying that:
- Option Premium = Intrinsic Value + Time Value
The moneyness of an option contract is simply a classification wherein each option (strike) gets classified as either – In the money (ITM), At the money (ATM), or Out of the money (OTM) option. This classification helps the trader to decide which strike to trade, given a particular circumstance in the market.
Understanding this option strike classification is very easy. All we need to do is figure out the intrinsic value.
If the intrinsic value is a positive, then the option strike is considered ‘In the money’. If the intrinsic value is zero the option strike is called ‘Out of the money’. The strike which is closest to the Spot price is called ‘At the money’.
The option chain helps you identify all the strikes that are available for a particular underlying and also classifies the strikes based on their moneyness. Besides, the option chain also provides information such as the premium price (LTP), bid –ask price, volumes, open interest etc. for each of the option strikes.
In The Money (ITM)
An in-the-money option has positive intrinsic value as well as time value.
A call option is in-the-money when the strike price is below the spot price.
A put option is in-the-money when the strike price is above the spot price
At The Money (ATM)
If the strike price is the same as the spot price, then it is called the “At-the-money” option.
An at-the-money option has no intrinsic value, it only has time value.
Out Of The Money (OTM)
An out-of-the-money option has no intrinsic value.
A call option is out-of-the-money when the strike price is above the spot price
A put option is out-of-the-money when the strike price is below the spot price