Option Basics: Pricing and “Moneyness”

05/18/2015 7:00 am EST

Focus: OPTIONS

J.W. Jones

Chief Options Strategist, Technical Traders, Ltd.

JW Jones of Option Trading Signals explains the basics of option pricing and the concept of "moneyness."

The peculiar vocabulary and concepts inhabiting an options trader's thoughts are often the source of confusion for visitors in the option world. I have often felt that learning to understand options is a lot like learning a foreign language. When you arrive in the country whose language you seek to learn, you need a functional vocabulary immediately.

In order to be able to understand my world, I thought it would be helpful to discuss a bit of my language since it is helpful to grasp a few basics. I want to touch on some of the basic concepts necessary to form the basis for a functional language we can use to communicate concepts underlying a (hopefully) rational thought process leading to trade design and management.

In rumination to come, we will return to these fundamental concepts and begin to understand their function in the dynamic world of an options trader. The nuances of their specific structures are beyond the scope of this article. We will return to consider these factors in virtually every trade because they re-appear each and every day in my world. For today, just shake their hands and remember their names.

One point not often discussed is the way in which options are priced. The quoted option price is in reality the sum of two separate components. These are referred to as the intrinsic and the extrinsic portions of the premium. I think of these as steak and sizzle, respectively.

This is an important distinction because it is the extrinsic premium which is subject to time decay and change due to variations in implied volatility.

The intrinsic premium is subject to change solely due to changes in the price of the underlying security. There is no sizzle in the intrinsic premium; you can buy the option today, exercise it to buy stock, sell the stock, and pocket the $5. Of course, your trading career will not last long with that sort of trade, but my point is that the intrinsic premium has an easily calculable true value.

The situation with the extrinsic premium is quite different. The value changes not only with time to expiration, but also with the constantly changing implied volatility. It is for this reason that an option trader must be very careful with this extrinsic component.

Depending on the specific option under consideration, extrinsic premium may represent all, a portion of, or a trivial amount of the entirety of the option premium.

Another important concept is that of the "moneyness" of an option. An individual option can be classified in one of three categories of "moneyness:"

  • At the money (ATM)

  • In the money (ITM)

  • Out of the money (OTM)

At-the-money options, by definition, consist of a single option strike price. Both in-the-money and out-of-the-money strikes usually contain several individual strikes within their groups.

Obviously, since the price of the underlying defines the category into which an option is classified, the category into which an individual option fits is fluid and changes dynamically with the price of the underlying asset.

The reason for taking the time to discuss in some detail this classification of "moneyness" is that there are important reliable characteristics of each type of option.

At-the-money options characteristically contain the absolute greatest dollar amount of extrinsic premium. In-the-money options have the least amount of extrinsic premium. Out-of-the-money options consist entirely of extrinsic premium and therefore only contain sizzle, no steak can be found there.

Because the functional characteristics of these three categories of options differ, it is a basic strategy to combine options of different "moneyness" to achieve trades with the best probability of success and the highest risk/reward scenarios.

For example, buying an in-the-money call and selling an at-the-money call gives birth to a call debit spread, a high-probability trade structure for the trader who is bullish on the underlying asset.

In the future, we will cover the stealth concept of option trading: implied volatility. Failure to understand the impact of this variable is the most common cause of beginning options traders' failure to succeed.

By JW Jones of Option Trading Signals

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