Moneyness is one of the easiest concepts in options trading to explain, because it' really quite straightforward. It's also absolutely fundamental to options trading and because of this, it's vital that anyone considering trading options should be familiar with it.
The definition of moneyness is simple; it's the relationship between the strike price of an options contract and the price of the underlying security. There are three main terms that are used to describe the moneyness of an options contract: in the money, at the money, and out of the money. A fourth term, near the money, can also be used.
The moneyness of an options contract basically changes between these states and when the price of the underlying security moves. On this page we provide details on each of these states, and also explain why options moneyness is so important.
- Out of the Money
- At the Money
- In the Money
- Near the Money
- Importance of Options Moneyness
Out of the Money
Options contracts are in an out of the money state when the underlying security is trading at a price that isn't favorable for the holder of those contracts. A call option would be out of the money if the strike price was higher than the price of the underlying security, while a put option would be out of the money if the strike price was lower than the price of the underlying security.
Remember, the price of an option is made up of two components: intrinsic value and extrinsic value. Intrinsic value relates to any built in profit that exists in an option, while extrinsic value is affected by other factors such as the amount of time left until expiration.
As out of the money contracts have no built in profit, their price is made up entirely of extrinsic value, and they are generally the cheapest options to buy. They can offer the opportunity for large profits, but you may need to see a significant move in the price of the underlying security for them to gain any intrinsic value. If an options contract reaches expiration in an out of the money state, then it would expire worthless.
At the Money
Options where the strike price is equal to the price of the underlying security are in an at the money state. At the money options also have no intrinsic value, so their price is also made up completely of extrinsic value. However, at the money options contracts will be more expensive than out of the money contracts because the price of the underlying security obviously has to move less to create intrinsic value. At the money options contracts are generally considered to provide a good balance of risk and reward.
Although the strict definition of at the money options is where the strike price is exactly equal to the price of the underlying security, such a situation is actually quite rare given the ever changing prices of stocks and other financial instruments that options can be based on. As such, at the money options are really where the underlying security is within a few cents of the strike price. If an options contract should reach expiration point and be exactly at the money, then it would expire worthless.
In the Money Options Contracts
In the money options are those that actually have some intrinsic value. A call option would be in an in the money state when the price of the underlying security is higher than the strike price, while a put option would be in the money when the price of the underlying security is lower than the strike price.
Basically, in the money options are ones that could be exercised at a profit. Because they have some built in profit, they are typically the most expensive options. It's generally recommended that beginners mostly stick to trading these, because it's much easier to control the element of risk even if they do tend to cost a bit more.
If you own in the money contracts where the expiration date is approaching, it's often a good idea to consider selling them. This is because they will usually be automatically exercised at the point of expiration, which may not be the best way for you to go.
For example, if you own in the money call options on a particular stock you may not want to actually own that stock. Even if you could sell it immediately at a profit, you would still incur commission charges for buying it and then selling it, so you might actually make more money by simply selling the contracts shortly before expiration and taking the profits from the intrinsic value and also any remaining extrinsic value.
Near the Money
Near the money isn't one of the three standard states of options moneyness, but it's still a fairly commonly used term. Near the money contracts are ones where the strike price is very close to the price of the underlying security. Basically, they are contracts that are either slightly in the money or slightly out of the money. They are often used by traders when a trading strategy requires the use of at the money contracts, but there are none available in the market.
Importance of Options Moneyness
Understanding moneyness and the various states of moneyness really is quite simple. They are some of the most commonly used phrases in options trading, which is why it's so important to be familiar with them. Every options trading strategy that you can use requires knowing what moneyness state the options you are buying or writing should be in. Even if you are just using very simple strategies that involve opening a single position, you still need to consider moneyness.
For example, if you are buying contracts on an underlying security that you are expecting to move dramatically in price in a relatively short time frame, then buying out of the money contracts would maximize your potential profits. If you are expecting a smaller movement, then in the money contracts would probably represent a better, and less risky, investment.
Once you start using some of the more complex strategies, moneyness becomes even more important. A number of advanced trading strategies involve taking multiple positions on different contracts, and for those strategies to work it's absolutely vital to trade contracts in the correct state of moneyness.
For example, a strategy might involve buying in the money contracts and then writing out of the money contracts on the same underlying security. If you don’t have a decent grasp of moneyness, it's all too easy to make mistakes and buy or sell contracts in the wrong state of moneyness. Providing you have a clear understanding of moneyness, you should be able to avoid such mistakes and use your chosen trading strategies appropriately.
