Options are like the hidden gems of the financial world, offering investors and traders the potential to profit from market movements without committing to owning or selling actual assets. But how do you determine if an option is in a favorable position for potential gains? What influences the price you pay for an option beyond its intrinsic value? How do European options differ from their American counterparts?
These concepts hold the power to transform seemingly complex jargon into actionable insights, empowering investors to make informed decisions. In this blog, we embark on a journey to simplify these terms and equip you with the knowledge to navigate the realm of options trading.
What Is Moneyness?
Moneyness is a concept that tells us whether a financial contract, like an option or a derivative, has the potential to be profitable based on the current market situation. It compares the relationship between the current market price of the underlying asset (like a stock, commodity, or currency) and the strike price specified in the contract.
The strike price is the price at which the financial contract allows you to buy or sell the underlying asset. For example, if you have an option contract that gives you the right to buy a certain stock at $50 per share, then $50 is the strike price.
The three main categories are:
1. In-the-Money (ITM)
An option is considered ITM when the current price of the stock in the real market is higher than the strike price mentioned in your call option contract. Here’s why this is good news: Imagine you have a call option that lets you buy a stock at $50, but the stock’s current market price is $60. If you were to exercise (use) your call option right now, you could buy the stock for $50 (thanks to your contract) and immediately sell it for $60 in the market. You’d make a $10 profit per share.
On the other hand, for a put option, being ITM means the current market price of the stock is lower than the strike price mentioned in your put option contract. Here’s why this is beneficial: Let’s say you have a put option that lets you sell a stock at $80, and the stock’s current market price is only $70. If you were to exercise your put option, you could sell the stock for $80 even though it’s only worth $70 in the market. You’d make a $10 profit per share.
2. At-the-Money Option (ATM)
An option is labelled ATM when the current market price of the stock is very close to the strike price mentioned in the option contract. In simple terms, let’s say you have a call option with a strike price of $50, and the stock’s current market price is around $50 as well. This situation is considered ATM.
At this moment, there is not much immediate profit potential in using the option. If you are holding an ATM call option, you would not make a significant profit by exercising it because you would be buying the stock for about the same price it is currently trading in the market. Similarly, if you are holding an ATM put option, selling the stock at the strike price wouldn’t result in a big profit because you could sell it for nearly the same price in the market.
3. Out-of-the-Money (OTM)
An option is OTM when the current market price of the underlying asset is not favorable compared to the strike price. For a call option, it’s OTM when the market price is lower than the strike price; for a put option, it’s OTM when the market price is higher than the strike price. In this situation, exercising the option wouldn’t make sense because you’d be buying or selling the asset at a less favorable price than what’s available in the market.
Moneyness helps investors and traders assess the immediate potential of a financial contract. An ITM option can be advantageous for making quick profits, an ATM option suggests a neutral situation and an OTM option is less valuable for immediate actions. Understanding moneyness is crucial when making decisions about trading or investing in financial markets.
Intrinsic Value
Intrinsic value is like the “real” or “actual” value of an option. It’s the amount by which an option is in the money and represents the immediate benefit that could be gained if the option were to be exercised right now.
- In-the-Money (ITM): For call options, the intrinsic value is calculated by subtracting the strike price from the current market price of the underlying asset. For put options, it’s the strike price minus the current market price. If this value is positive (greater than zero), the option has intrinsic value. It’s like the profit you could make instantly if you used the option.
- At-the-Money (ATM): At-the-money options have no intrinsic value because the current market price and the strike price are essentially the same. So, the intrinsic value for ATM options is always zero.
- Out-of-the-Money (OTM): Out-of-the-money options have zero intrinsic value as well because the current market price is not favorable compared to the strike price. The intrinsic value is negative for OTM options.
Extrinsic Value
Extrinsic value, also called time value or premium value, is the extra amount that you’re paying for an option over its intrinsic value. It’s like the potential value that the option might have in the future due to factors like time left until expiration and market volatility.
As an option gets closer to its expiration date, its extrinsic value tends to decrease. This is because there’s less time for the option’s market price to change, potentially moving it from out of the money to in the money.
Extrinsic value also considers market volatility. If the underlying asset is expected to have larger price swings, the extrinsic value will be higher because there’s a greater chance that the option’s value could change significantly before it expires.
Conclusion
In conclusion, our exploration into options trading has illuminated critical concepts: moneyness, intrinsic value, extrinsic value, and European options. Moneyness categorizes options based on market relationships, intrinsic value gauges immediate worth, and extrinsic value encompasses time and volatility factors. This understanding equips you to evaluate options contracts astutely.
As we wrap up, consider this a call to delve deeper into options trading, further enhancing your comprehension and seizing new opportunities that beckon.