Understanding the Money Ness of a put option - Motilal Oswal
Understanding the Money Ness of a put option - Motilal Oswal

Understanding the Moneyness of a put option

Just as the concept of moneyness is applicable to call options, it is also applicable to put options. The only difference is that the concept of ITM and OTM operates in the other direction when it comes to the relationship between the strike price and the spot price of the stock. The moneyness of put option is basically a determinant of whether the particular option has a positive intrinsic value or an intrinsic value of zero. Remember, intrinsic value of an option can never be negative; the lowest possible intrinsic value of an option is zero. The reason moneyness of an option is important in that it determines whether the option is valuable or not. When it comes to puts should you buy ITM or OTM options? What is the difference between in the money and out of the money options in puts?

Intrinsic value of a put option..
A put option is a right to sell an underlying asset without the obligation to sell. You will typically buy a put option on a stock when you expect the stock price to go down i.e. you are bearish on the stock. So the buyer of the put option gets the right to sell without the obligation to sell. The seller of the put option has an obligation to buy at the agreed price and on the agreed date. Since the seller of the put option gives an unfettered right to the buyer of the option, he will charge him a price for this right. The price of the right that the buyer has to pay to the seller of the put option is called the option price or the option premium.
Let us take the example of SBI with a spot price at Rs.275. The 290 put option on SBI for the March 2018 series is available at an option price of Rs.23. Now let us break up this option premium into two components.
 

Details of the Put OptionPrice of the Put OptionCommentSBI 290 Put (Mar 2018)Rs.23This is the price paid by the buyer for the right to sellIntrinsic value of the SBI put optionsRs.15
(290-275)Since the price is already Rs.15 lower than strike priceTime value of the SBI put optionRs.8
(23 – 15)It is the residual value implied in the put price

 
As can be seen from the above example, the intrinsic value is embedded in the market price. If the spot price of SBI goes down to Rs.270, the intrinsic value of the put option becomes Rs.20. It is a positive intrinsic value that determines the moneyness of the put option and decides whether the option should be exercised or not. For a put option to have moneyness, the spot price of the stock should be lower than the strike price of the option. That is because a put option is the right to sell.

3 levels of moneyness of put options (ITM, ATM and OTM)..
There are 3 types of moneyness that applies to put options. Let us consider these 3 different types of moneyness in case of the put option for SBI 290 put..

In-the-Money (ITM) Put Option: If the strike price of the SBI put is above the market price then the option becomes ITM. In the above case since spot price of SBI is Rs.275, all SBI put strikes of 280 and above will be ITM in terms of moneyness of the put option.

At-the-Money (ATM) Put Options: If the strike price of the SBI put is the same as the market price then the option becomes ATM. In the above case, the SBI put strike of Rs.275 will be ITM in terms of moneyness.

Out-of-the-Money (OTM) put option: If the strike price of SBI put is below the market price then the option becomes OTM. In the above case, all SBI put strikes of 270 and below will be OTM in terms of moneyness of the put option.

Understanding Moneyness with a put option value table..
Let us understand moneyness of the SBI put option for different strikes when the spot price of SBI is Rs.275.

SBI StrikeOption  premiumIntrinsic valueTime Value24010124520225020225540426050526560627060627570728012572851710729023158295312011300372512305463016310503515

 
In case of the SBI put option on Strikes 280 to 310 are ITM options as they have a positive intrinsic value. The 275 strike is ATM as at that point the strike price and the spot price is the same so the option buyer becomes indifferent. From strikes of 270 and below, the options are OTM in terms of moneyness as their intrinsic value is zero. The entire option premium in these cases is represented by the time value of the option alone.
 
Why is moneyness of a put option so important?
Typically, options can either be exercised or they can be sold in the market to square up your positions. The concept of moneyness is important for puts because the option will be exercised only in case of ITM options, not for ATM and OTM options. There is an interesting point to consider here. Moneyness of put options has nothing to do with the premium and is only concerned with the relationship between market price and strike price. If you have bought a 280 put option on SBI at Rs.8 and the stock price is now Rs.275, you will end up with a net loss of Rs.3 (5-8). But in terms of moneyness this put option is still an ITM option because the moneyness of the option is helping you to reduce your losses. That is what moneyness of put options is all about!
 
 

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