Fx options moneyness

What Is Moneyness?

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.

What Is Option Moneyness?

You may have heard the terminology before: in the money, at the money, out of the money; but what does it all mean?

These terms all refer to one aspect of options trading - moneyness - and finding out what it means has important implications for options traders. This article attempts to cover the basic concepts of option valuation, so that you can move on to building your model with a better understanding of its vital foundation. (For more basic information, read Understand Option Pricing .)

[ Everyone is trying to me "in-the-money", but it takes a solid understanding of options and options pricing to get there. Learn the basics of options, as well as gain practical tools and trading strategies, in Investopedia Academy's Options for Beginners course. ]

Elements Of Option Pricing.

An option quote usually contains the following information:

Name of underlying asset - ie. shares, let's call it ABC Expiration date - ie. December Strike price - ie. 400 Class - ie. call.

Another important element is the option premium, which is the amount of money that the buyer of an option pays to the seller for the right, but not the obligation, to exercise the option. This should not be confused with the strike price, which is the price at which a specific option contract can be exercised.

The above elements work together to determine the moneyness of an option - a description of the option's intrinsic value, which is related to its strike price as well as the price of the underlying asset. (For more on the fundamentals of options trading, see our Options Basics tutorial.)

Intrinsic Value And Time Value.

The option premium is broken down into two components: the intrinsic value and the speculative or time value. The intrinsic value is an easy calculation - the market price of an option minus the strike price - and it represents the profit that the holder of the option would enjoy if he or she exercised the option, took delivery of the underlying asset and sold it in the current marketplace. The time value is calculated by subtracting the intrinsic value of the option from the option premium.

For example, let's say it's September and Pat is long (owns) a December 400 call option for ABC stock. The option has a current premium of 28 and ABC is currently trading at 420. The intrinsic value of the option would be 20 (market price of 420 - strike price of 400 = 20). Therefore, the option premium of 28 is comprised of $20 of intrinsic value and $8 of time value (option premium of 28 - intrinsic value of 20 = 8).

Pat's option is in the money. An in-the-money option is an option that has intrinsic value. With regard to a call option, it is an option with a strike price below the current market price. It would make the most financial sense for Pat to sell her call option, as then she would get $8 more per share than she would by taking delivery of the shares (calling them away) and selling them in the open market.

Selling deep-in-the-money covered calls presents a trader with the opportunity to take some of their profit immediately, as opposed to waiting until the underlying stock is sold. It also can be very profitable when a long stock appears to be overbought, as this would increase the intrinsic value and often the time value as well, due to the increase in volatility. (For more on this option strategy, read The Basics Of Covered Calls . For more on the importance of volatility in option trading, see our Option Volatility tutorial.)

Returning to our example, if Pat were long a December 400 ABC put option with a current premium of 5, and if ABC had a current market price of 420, she would not have any intrinsic value (the entire premium would be considered time value), and the option would be out of the money. An out-of-the-money put option is an option with a strike price that is lower than the current market price.

The intrinsic value of a put option is determined by subtracting the market value from the strike price (strike price of 400 - market value of 420 = -20). Intuitively, it looks as if the intrinsic value is negative, but in this scenario the intrinsic value can never be negative; the lowest it can ever be is zero.

A third scenario would be if the current market price of ABC was 400. In that case, both the call and put options would be at the money, and the intrinsic value of both would be zero, as immediate exercise of either option would not result in any profit. However, that doesn't mean that the options have no value - they could still have time value. (For tips on more-advanced option-trading options, see our Option Spreads tutorial.)

The Importance Of Time Value.

Time value is the main reason that there is very little exercising of options and a lot more closing out, offsetting, covering and selling of contracts. In our example above, Pat would have increased her profit by 40% ($8/$20) by selling her call option instead of taking delivery of the stock and selling the actual shares. The $8 covers the speculation that exists in regard to the price of ABC between September and expiration in December.

The market determines this part of the premium; however, it is not just a random assessment. Many factors come into play in the establishment of the time value of an option. The Black-Scholes option pricing model, for example, relies on the interplay of five separate factors:

price of the underlying asset strike price of the option standard deviation of the underlying asset time to expiration risk-free rate.

In summary, understanding the basics of valuing options can be said to be part science and part art. It is vital to understand where profits come from and what they are expected to represent, in order for option-trading profits to be maximized.

For discussion and evaluation of actual option pricing models, see our Employee Stock Options tutorial.

Moneyness.

DEFINITION of 'Moneyness'

A description of a derivative relating its strike price to the price of its underlying asset. Moneyness describes the intrinsic value of an option in its current state.

BREAKING DOWN 'Moneyness'

Moneyness tells option holders whether exercising will lead to a profit. There are many forms of moneyness, including in, out or at the money. Moneyness looks at the value of an option if you were to exercise it right away. A loss would signify the option is out of the money, while a gain would mean it's in the money. At the money means that you will break even upon exercising the option.

Implied volatility and Moneyness.

Implied volatility and Moneyness.

This is a discussion on Implied volatility and Moneyness within the Futures & Options forums, part of the Markets category; Gentlemen, I'm having difficulty with this. Maybe some kind soul will take pity. Assume a 5000 strike is 250 points .

Ex nihilo, nihil fit.

How can the shift in the underlying be reflected via an adjustment to the iv figure?

Every time you record an implied vol, also record the delta of the option for which it is the vol. That way you have a ready point of reference which factors in the strike and expiry time in the way that matters (monyness).

Good judgment comes from experience. Experience comes from bad judgment.

Originally Posted by grantx View Post.

Given that the implied vol is observed in the market place, why would you want to adjust it because the underlying has moved ?

Originally Posted by NotQuiteRandom View Post.

Profitaker, you are right that "if an OTM option saw it’s IV spike (for whatever reason) the delta would. " increase. This however reflects a change in the market's expectation of the volatility at that strike / tenor. This perceived change in probability is reflected in the change in delta as a consequence of the vol spike. In turn, this relates to the degree of moneyness.

Ex nihilo, nihil fit.

Think of it like this, the (spot) market need not move for an effective change in moneyness where we qualify moneyness in terms of the probability of the market reaching a certain point.

Good judgment comes from experience. Experience comes from bad judgment.