Moneyness

What Is Moneyness?

Moneyness is a classification of an options contract that describes the relationship between the underlying asset's current price and the option's strike price. It categorizes an option as being "in-the-money," "at-the-money," or "out-of-the-money," indicating its intrinsic value and immediate profitability if exercised. This concept is fundamental to understanding options trading, a key area within derivatives and broader financial markets. Moneyness helps traders and investors quickly assess an option's potential profitability and its sensitivity to price movements of the underlying asset.

History and Origin

The concept of moneyness, while perhaps not formalized with that specific term, has been inherent in options contracts since their earliest forms, which date back centuries. Early options, such as those speculated on olive harvests in ancient Greece, or later, on commodities in the Dutch Tulip Mania, implicitly carried the idea of whether the future price made the contract valuable or not.⁷, ⁸ However, the modern understanding and standardization of options trading, which made the concept of moneyness more explicit and universally applicable, largely began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973.⁶ Before the CBOE, options were primarily traded over-the-counter (OTC) with varying terms. The CBOE introduced standardized contracts, which facilitated clearer definitions and widespread use of terms like moneyness in assessing an option's immediate value.⁴, ⁵ This standardization also paved the way for more sophisticated pricing models, further integrating the concept of moneyness into quantitative analysis.

Key Takeaways

• Moneyness classifies an option based on the relationship between its strike price and the current price of the underlying asset.
• Options can be "in-the-money" (ITM), "at-the-money" (ATM), or "out-of-the-money" (OTM).
• In-the-money options have positive intrinsic value and would be profitable if exercised immediately.
• Out-of-the-money options have no intrinsic value and would not be profitable if exercised immediately.
• At-the-money options have a strike price equal or very close to the underlying asset's current price.

Formula and Calculation

Moneyness is not calculated with a numerical formula in the way that option premium or intrinsic value is. Rather, it is a categorical classification based on a comparison.

For a call option:

• In-the-Money (ITM): The underlying asset's price ((S)) is greater than the strike price ((K)).
  $S > K$
• At-the-Money (ATM): The underlying asset's price ((S)) is equal or very close to the strike price ((K)).
  $S \approx K$
• Out-of-the-Money (OTM): The underlying asset's price ((S)) is less than the strike price ((K)).
  $S < K$

For a put option:

• In-the-Money (ITM): The underlying asset's price ((S)) is less than the strike price ((K)).
  $S < K$
• At-the-Money (ATM): The underlying asset's price ((S)) is equal or very close to the strike price ((K)).
  $S \approx K$
• Out-of-the-Money (OTM): The underlying asset's price ((S)) is greater than the strike price ((K)).
  $S > K$

The classification directly impacts the option premium, particularly its intrinsic value component.

Interpreting the Moneyness

Interpreting moneyness is crucial for understanding an option's immediate profitability and its sensitivity to market movements. An in-the-money option for a buyer means the option has current value and could be profitably exercised. For sellers, it implies a potential liability. Out-of-the-money options have no intrinsic value; their entire premium consists of time value and extrinsic factors like volatility. Such options are often cheaper but require a significant move in the underlying asset's price before their expiration date to become profitable. At-the-money options are typically the most sensitive to small price changes in the underlying asset, making them popular for certain trading strategies. The degree of moneyness (how far in or out of the money an option is) also influences its delta, a measure of an option's price sensitivity to changes in the underlying asset's price.

Hypothetical Example

Consider XYZ stock trading at $100 per share.

• Call Option Scenario:

  • A call option with a strike price of $95 is in-the-money because the underlying price ($100) is greater than the strike price ($95). If exercised, the holder could buy XYZ for $95 and immediately sell it in the market for $100, realizing a $5 profit per share before factoring in the premium paid.
  • A call option with a strike price of $100 is at-the-money because the underlying price ($100) is equal to the strike price ($100).
  • A call option with a strike price of $105 is out-of-the-money because the underlying price ($100) is less than the strike price ($105). Exercising this option would mean buying XYZ for $105 when it can be purchased for $100 in the open market, resulting in a loss.

• Put Option Scenario:

  • A put option with a strike price of $105 is in-the-money because the underlying price ($100) is less than the strike price ($105). If exercised, the holder could sell XYZ for $105 when it can be bought for $100 in the market, realizing a $5 profit per share before factoring in the premium paid.
  • A put option with a strike price of $100 is at-the-money because the underlying price ($100) is equal to the strike price ($100).
  • A put option with a strike price of $95 is out-of-the-money because the underlying price ($100) is greater than the strike price ($95). Exercising this option would mean selling XYZ for $95 when it can be sold for $100 in the open market, resulting in a loss.

Practical Applications

Moneyness is a core concept in various practical applications within finance and investing:

• Trading Strategy Selection: Traders often choose options based on their moneyness. For example, aggressive traders might prefer out-of-the-money options for high leverage and lower upfront cost, while those seeking immediate intrinsic value might choose in-the-money options.
• Hedging and Risk Management: Investors use options for hedging. Understanding moneyness helps them select the appropriate strike price to protect against adverse price movements. For instance, an investor holding a stock might buy an out-of-the-money put to limit downside risk without excessive cost.
• Speculation: Speculators use moneyness to gauge the likelihood and potential payoff of their bets. Buying out-of-the-money options is a common speculative strategy due to their lower cost, offering significant returns if the underlying asset moves sharply in the desired direction.
• Option Pricing Analysis: Moneyness directly influences an option's premium. Options that are deep in-the-money tend to have premiums dominated by intrinsic value, while out-of-the-money options are priced solely by their time value and implied volatility. Regulators, such as the U.S. Securities and Exchange Commission (SEC), oversee the options markets to ensure fair pricing and transparency.³
• Market Statistics: Financial exchanges and data providers, like Cboe Global Markets, often report historical options data categorized by moneyness to provide insights into trading activity and investor sentiment.² This data can be analyzed to understand market trends and liquidity for different option series.

Limitations and Criticisms

While moneyness is a useful classification, it has limitations:

• Static Classification: Moneyness is a static measure at a given point in time. An option's moneyness can change rapidly with small movements in the underlying asset's price, especially for at-the-money options.
• Incomplete Picture: Moneyness does not account for an option's full value. It only addresses intrinsic value. The extrinsic value, which includes time value and implied volatility, can significantly impact an option's premium, particularly for out-of-the-money and at-the-money options. Therefore, an in-the-money option may still lose money if its premium (which includes both intrinsic and extrinsic value) was higher than the current intrinsic value when purchased.
• No Profit Guarantee: An in-the-money classification does not guarantee a profitable trade. The profitability of an option trade depends on the original purchase price (the option premium) relative to the final value at expiration or when the option is closed. For example, derivative pricing models, such as the Black-Scholes model, integrate factors beyond just moneyness to determine an option's theoretical value.¹
• Context Dependency: The "moneyness" of an option is relative to the current market price and specific strike. Its significance varies depending on the overall market conditions, volatility, and time until expiration.

Moneyness vs. Intrinsic Value

Moneyness and intrinsic value are closely related concepts in options trading but are not interchangeable. Moneyness is a classification of an option's status (in-the-money, at-the-money, or out-of-the-money) based on the relationship between the underlying asset's price and the option's strike price. It's a qualitative description.

Intrinsic value, on the other hand, is a quantitative component of an option's premium. It represents the immediate profit that could be realized if an option were exercised. Only in-the-money options have intrinsic value. Out-of-the-money and at-the-money options have zero intrinsic value. For example, a call option with a strike price of $50 on a stock trading at $55 has an intrinsic value of $5, and it is classified as "in-the-money." If the stock were trading at $45, the call option would have an intrinsic value of $0 and be classified as "out-of-the-money."

FAQs

Q1: Why is moneyness important in options trading?
A1: Moneyness is important because it provides a quick assessment of an option's immediate profitability and its potential for gaining intrinsic value. It helps traders understand the risk-reward profile of an options contract and choose strategies aligned with their market outlook.

Q2: Can an out-of-the-money option become in-the-money?
A2: Yes, an out-of-the-money option can become in-the-money if the price of the underlying asset moves favorably before the option's expiration date. For a call option, the underlying price must rise above the strike price. For a put option, the underlying price must fall below the strike price.

Q3: Does moneyness tell me how much I will profit?
A3: No, moneyness only indicates whether an option has intrinsic value. The actual profit or loss from an option trade depends on the option premium paid (or received) and the option's value at the time it is closed or exercised.