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Moneyness isn’t a word, is it? It won’t be found on spell-check, but moneyness is a very important term when it comes to options. There are three degrees, if you will, of moneyness for an option: at-the-money (ATM), in-the-money (ITM) and out-of-the-money (OTM). Let’s take a look at each of these terms, using theoretical stock XYZ as an example. Imagine XYZ is trading around the $320 level, so let’s define the moneyness of XYZ options relative to their $320 price.
An at-the-money XYZ option is a call or a put option that has a strike price about equal to $320. The ATM options (in XYZ's case the 320-strike put or call) have only time value, a factor that decreases in value as the option’s expiration date approaches, also referred to as time decay. ATM options are greatly influenced by the underlying stock’s volatility and the passage of time.
An option that is in-the-money is one that has intrinsic value in addition to time value. A call option is ITM if the strike price is below the underlying stock’s current trading price. In the case of XYZ, ITM options include the 315 strike and every strike below that. One will notice that option positions that are deeper ITM have higher premiums. In fact, the further in-the-money, the deeper the premium.
A put option is considered ITM when the strike price is above the current trading price of the underlying. For our example, with XYZ at 320, an ITM XYZ put would carry a strike price of 325 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, an XYZ 330 put has a premium of $12.30 compared to a premium of $3.80 for a 310 put.
If an option expires ITM, it will be automatically exercised or assigned. For example, if a trader owned an XYZ 315 call and XYZ closed at $320 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of XYZ stock at $315 a share.
Think of it this way: whether a put or call, an ITM option represents a sweet deal relative to market price. ITM calls let you buy the underlying stock for cheaper than current market price; ITM puts let you sell for more than the market currently demands.
An option is out-of-the-money when it has no intrinsic value. Calls are OTM when their strike price is higher than the market price of the underlying, and puts are OTM when their strike price is lower than the stock’s current market value. Since the OTM option has no intrinsic value, it holds only time value. OTM options are cheaper than ITM options because there is a greater likelihood of them expiring worthless.
If this is the case, why purchase OTM options? If you have little investing capital, an OTM option carries a lower premium; but you are paying less because there is a higher possibility that the option expires worthless. OTM options are attractive because OTM calls can see their premium increase quickly. Of course, OTM options could see their premium decrease quickly as well. Remember that OTM options can log the highest percentage gain on the same move in the underlying, in comparison to ATM or ITM options.
Founder, Markettaker Mentoring
TradeKing All-Star Commentator
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
Dan Passarelli maintains a cross-marketing relationship with TradeKing.