For anyone who wishes to get involved in the world of options trading, it is vital to understand the concept of option moneyness and how it relates to the price and other important aspects of the option.
Before the concept of moneyness is explained, it is important to recap what is meant by the strike price of an option. Sometimes also called the exercise price, the strike price is simply the price at which the option seller and the option buyer agree to trade the underlying asset at a specific future time.
At the money (ATM) options
This is perhaps the simplest to understand and a good introduction to working with moneyness. With ATM options the strike price is equal to the current market price of the underlying asset. When a trader buys a 1-month ATM option on a particular share, he or she gains the right to buy the agreed number of shares at the same price as today one month from now.
Out of the money (OTM) options
When the strike price of a call option is higher than the current price of the underlying asset, that option is said to be out of the money (OTM). For a put option the reverse is true: the strike price has to be lower than the current price.
In the money (ITM) options
For some traders this is the most confusing concept to grasp, but it’s not really all that complicated. An in the money (ITM) option is simply a call option with a strike price lower than the current price of the asset. An in the money put option is one where the strike price is higher than the current market price of the underlying asset.
Strike prices as they relate to the options price
The reason why it’s so important to grasp moneyness of options is because it plays the single most important role in the price of that option.
A OTM option is the cheapest type of option a trader can buy. The reason for that is relatively simple: the underlying asset price must first move to the strike price before the trader will make any money on such an option. If a particular share is trading at $100 today and a trader buys a 3-month call option with a strike price of $120 on that share, the option will expire worthless if the share price remains the same or rises to less than $120 (plus the cost of the option) by the expiry date.
Someone buying an ATM call option will immediately benefit if the underlying stock price increases by more than the cost of the option before the expiry date. ATM options are consequently more expensive than OTM options.
A call option is in the money when the strike price is below the current price of the underlying asset. For a put option that would be the case if the strike price is above the current market price of the asset.
ITM options are the most expensive. The reason for this is that they already have what is called ‘intrinsic’ value. Even if the price of the underlying asset price remains the same upon expiry, the buyer of an ITM call or put option will not lose the full purchase price as is the case with an OTM or ATM option – he or she will retain this intrinsic value part of the option.