Know the “Moneyness” of Options

06/27/2011 11:08 am EST

Focus: STOCKS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

Understanding the three degrees of “moneyness” (at-the-money, in-the-money, and out-of-the-money) is an important aptitude for any option trader.

“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 tech behemoth Apple (AAPL) as an example.

At the time of writing, Apple was hovering around the $320 level, so let’s define the moneyness of Apple options using $320 as the price.

At-the-Money Options

An at-the-money AAPL option is a call or a put option that has a strike price about equal to $320. The ATM options (in Apple’s case, the 320-strike put or call) have only time value (a factor that decreases as the option’s expiration date approaches; also referred to as time decay). These options are greatly influenced by the underlying stock’s volatility and the passage of time.

In-the-Money Options

An option that is in the money is one that has intrinsic value. A call option is ITM if the strike price is below the underlying stock’s current trading price. In the case of AAPL, 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, an ITM AAPL put carries a strike price of 325 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, an AAPL 330 put has a premium of $12.30 compared to a price 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 AAPL 315 call and AAPL closed at $320 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of AAPL at $315 a share.

Out-of-the-Money Options

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.

By Dan Passarelli of MarketTaker.com

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