A popular term pertaining to options is the moneyness of the option. The moneyness of an 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 is that it determines whether the option is valuable or not. To understand moneyness we first need to understand the concept of intrinsic value of an option. Let us look at moneyness of a call option in this case. Let us also look at the moneyness of options and the larger concept of moneyness in options..
Intrinsic value of a call option
As we are aware, a call option is a right to buy an underlying asset without the obligation to buy. So the buyer of the call option gets the right to buy without the obligation to buy. The seller of the call option has an obligation to sell at the agreed price and on the agreed date. Since the seller of the call 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 call 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 260 call 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 Call OptionPrice of the Call OptionCommentSBI 260 Call (Mar 2018)Rs.23This is the price paid by the buyer for the rightIntrinsic value of the SBI call optionsRs.15
(275-260)Since the price is already Rs.15 more than strike priceTime value of the SBI call optionRs.8
(23 – 15)It is the residual value implied in the option 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 up to Rs.280, the intrinsic value of the call option becomes Rs.20. It is a positive intrinsic value that determines the moneyness of the call option and decides whether the option should be exercised or not.
3 levels of moneyness of call options (ITM, ATM and OTM)..
There are 3 types of moneyness that applies to call options. Let us consider these 3 different types of moneyness in case of the call option for SBI 260 call..
In-the-Money (ITM) Call Option: If the strike price of the SBI call is below the market price then the option becomes ITM. In the above case since spot price of SBI is Rs.275, all SBI call strikes of 270 and below will be ITM in terms of moneyness.
At-the-Money (ATM) Call Options: If the strike price of the SBI call is the same as the market price then the option becomes ATM. In the above case, the SBI call strike of Rs.275 will be ITM in terms of moneyness.
Out-of-the-Money (OTM) call option: If the strike price of SBI call is above the market price then the option becomes OTM. In the above case, all SBI call strikes of 280 and above will be OTM in terms of moneyness.
Understanding Moneyness with a call option value table..
Let us understand moneyness of the SBI call option for different strikes when the spot price of SBI is Rs.275.
SBI StrikeOption premiumIntrinsic valueTime Value24050351524546301625037251225531201126023158265171072701257275707280606285606290505295404300202305202310101
In case of the call option on Strikes 240 to 270 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 280 and above, 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 call 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 calls 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 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 call option on SBI at Rs.8 and the stock price is now Rs.285, you will end up with a net loss of Rs.3. But in terms of moneyness this call options is still an ITM option because the moneyness of the option is helping you to reduce your losses. That is what moneyness of a call options is all about!