by Amanda Harvey
Moneyness is a trading term which refers to the relationship between an option’s strike price, and the market price of the underlying security (mostly a stock for our purposes) at any given moment. It relates to whether or not a trader would or would not make money by exercising the option at that time. The level of moneyness also affects the value of the actual option contract, as a contract that is described as being ‘in-the-money’ contains intrinsic value as well as time value.
There are three basic classifications of the moneyness of an options contract, and the desirability of these levels is fairly apparent in their names. The first brings to mind the 1930s show tune, “We're in the Money,” and is clearly what a trader would hope for every options contract they enter.
When an options contract is ‘in-the-money', it means that the trader could make money by exercising the contract. In the case of a call option, being in-the-money occurs when the market price of the underlying security is higher than the strike price of the option contract. The trader is entitled to buy the number of shares specified in the contract at the agreed price, which is known as the strike price. These shares which are purchased at below market value could then be resold at market value, generating an immediate profit. Alternatively the option contract could be re-sold at a higher premium than the trader paid for it, which is a way of attaining a profit without the amount of capital outlay needed to buy and then sell the stocks. It is important to be aware of the moneyness of an option contact which is approaching expiration, as in the case of a call option expiring in-the-money, the trader is generally obligated to purchase the stocks, unless prior arrangement has been made with their broker.
An in-the-money put option reflects the reverse scenario, where the market price of the stocks is below the strike price of the option contract. The trader is then able to sell the shares as specified in the contract at a higher than market value, and then purchase them again for the lower rate at which they are currently trading. The trader can also choose to sell their options contract in the same manner as with a call option, obtaining a premium higher than the one they paid to enter the contract.
The second level is when an option contract is ‘at-the-money.’ As implied by the name, this is a break-even point, where the strike price matches the market value of the stock. It is worthwhile to realize that this condition of being at-the-money is not only infrequent, but it is typically also fleeting, due to the fact that stock prices are constantly changing. A less frequently used term, but one that is more often applicable, is ‘near-the-money.’ This refers to option contracts with strike prices that are close to the market price of the underlying stock.
The third state of moneyness of an option contract is when it is ‘out-of-the-money.’ This is when the market price is lower than the strike price in the case of a call option, and the opposite with a put option. If a trader were to exercise the contract on an out-of-the-money option, they would sustain a loss. If the trader sold the contract, they would receive a lower premium than the one they originally paid. Traders may choose to do this, especially when using a stop loss, in order to recoup a portion of their initial outlay.
An out-of-the-money option contains no intrinsic value, but holds a component of time value which depends on the length of time before expiration. More time before expiration provides a greater opportunity for the option to regain its value, and potentially attain the status of being in-the-money. Closer to expiration, the time-value component of an out-of-the-money option dwindles, and if it expires out-of-the-money it is worthless.
A note of caution is to avoid buying out-of-the-money options, which new traders may be tempted to do because they are cheap. Unless you have very good reasons to believe that the time value is sufficient, and the indications are strong enough for it make a turnaround within the time-frame of the contract, then you are not getting a bargain.
Conversely, a strongly in-the-money option is more expensive, and you need to have reason to believe that there is sufficient potential for further growth, in order to make it a viable trade to enter.
A near-the-money option with strong indications of movement in the direction of the trade you are considering can be a very good scenario when entering a trade.
When trading stock options, it is important to consider the
level of moneyness of the potential trade, the cost of entering the trade
compared to the value that can be obtained, and the probability that it will
continue to move in your favor.