Option Contract moneyness What It Is and How It Works

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Intrinsic Value

The moneyness of an option contract is a classification system that assigns each strike to one of three categories – In the money, At the money, or Out of the money – and assists in determining which one to trade for a given market situation. To begin with, let us review the concept of intrinsic value again.

An option holder has the right to purchase 100 shares for Rs.50 on the given day. If the share price is $60 then this option has intrinsic value of Rs. 1000 (Rs. 60 – Rs. 50 * 100).

Suppose you acquired the 8050CE and you had the option of exercising it now, not waiting for 15 days until it expired. My inquiry to you is – what amount of money would you be in a position to make by exercising the contract at present?

Recalling when exercising a long option, the money made is equal to the intrinsic value of it minus the premium paid, to answer the query requires us to draw up the call option intrinsic value formula from the previous chapter.

Here is the formula –

Spot Price – Strike Price = Intrinsic Value (IV) of a Call option

 

Let us plug in the values

= 8070 – 8050

= 20

Therefore, if you choose to exercise the option at this moment, you have the potential to gain 20 points (without considering the premium paid).

This table provides intrinsic values for various options strikes. The numbers shown are simply there to demonstrate the concept.

I hope that this has enlightened you on the intrinsic value of an option strike. Note the following: 

  1. The intrinsic worth of an option is the profit one would generate if they were to act on the contract.
  2. The intrinsic value of an option is always equal to or greater than zero. It can never be negative.
  3. For a call option, the intrinsic value is calculated by subtracting the strike price from the spot price. 
  4. On the other hand, for a put option, the intrinsic value is determined by subtracting the spot price from the strike price.

Before we conclude this conversation, can you tell me why the inherent value cannot be negative?

To answer this, we can select an example from the earlier table. For instance, let us assume that the strike is 920, the spot is 918 and it is a long call option. The premium for this particular call is Rs.15.

Now,

  1. If you were to execute or exercise this option, what would be the outcome?
    1. Clearly, we get the intrinsic value.
  2. How much is the intrinsic value?
    1. Intrinsic Value (IV) = Strike Price – Spot Price = 918 – 920 = -2
  3. The formula suggests we get ‘– Rs.2’. What does this mean?
    1. This implies that there is a loss of Rs.2
  4. Let’s assume this scenario to be true for a moment; what would be the overall loss incurred?
    1. 15 + 2 = Rs.17/-
  5. However, it is important to remember that the downside of owning a call option is limited to the cost of the premium, in this case Rs.15/-
    1. If we include a negative intrinsic value, it contradicts the non-linear property of option payoff. That is, we would witness a Rs.17/- loss as opposed to Rs.15/-. To preserve this non-linear property, the intrinsic value must not be negative.
  6. The same principle can be applied to the intrinsic value of a put option.

Hopefully this will shed some light on why an option’s intrinsic value cannot become negative.

 – Moneyness of a Call option

Rehashing our talk concerning the inherent worth of an option, understanding moneyness should be straightforward. Moneyness is a way to classify each strike price based on what a trader will receive from exercising their option contract today. This can be broken down into three categories –

  1. In the Money (ITM)
  2. At the Money (ATM)
  3. Out of the Money (OTM)

Here’s how it can be classified in the best way possible: 

  1. Deep In the money
  2. In the Money (ITM)
  3. At the Money (ATM)
  4. Out of the Money (OTM)
  5. Deep Out of the Money

Knowing the intrinsic value, it’s simple to identify the strike classification. To be classified as ‘In the money’ the option must have a non-zero intrinsic value. When the situation described above does not occur, it is commonly referred to as being ‘Out of the money’. On the other hand, if the strike price is closest to the spot price, it is referred to as being ‘At the money’.

 

Let’s use an illustration to gain a better understanding of this. Currently (7th May 2015) the Nifty is at 8060 and I have chosen to outline the available strike prices (the blue box indicates which ones). The aim is to divide these strikes into ITM, ATM, or OTM. We can talk about ‘Deep ITM’ and ‘Deep OTM’ subsequently.

Upon examining the image, it becomes apparent that the range of strike prices available for trading spans from 7100 to 8700.

We can start by recognising ‘At the Money Option (ATM)’ since it is the least difficult to handle.

From earlier, we learned that the ATM option is the option strike closest to the spot price. Currently, the spot is at 8060, so 8050 is likely the ATM option. There isn’t an 8060-strike available, which makes 8050 the next closest and therefore, ATM.

Having set up the 8050 option, we can now begin to pinpoint ITM and OTM variations. We shall choose several strikes and work out their intrinsic value.

  1. 7100
  2. 7500
  3. 8050
  4. 8100
  5. 8300

Remember to keep the spot price of 8060 in mind when considering the intrinsic value for strikes above this.

@ 7100

Intrinsic Value = 8060 – 7100

= 960

As the value is non-zero, it indicates that the strike should correspond to an In the Money (ITM) option.

@7500

Intrinsic Value = 8060 – 7500

= 560

As the value is non-zero, it indicates that the strike should correspond to an In the Money (ITM) option.

@8050

 Since the strike price of 8050 is closest to the spot price of 8060, we can consider it as the At The Money (ATM) option. Therefore, we don’t need to calculate its intrinsic value as it is not applicable in this case.

@ 8100

Intrinsic Value = 8060 – 8100

= – 40

Negative intrinsic value, therefore the intrinsic value is 0. Therefore, the strike is Out of the Money (OTM).

@ 8300

Intrinsic Value = 8060 – 8300

= – 240

The negative intrinsic value indicates that the option has no intrinsic value and is considered Out of The Money (OTM). It’s worth noting the generalisations that apply to call options in this context.

  1. All option strikes that are higher than the ATM strike are categorised as Out of The Money (OTM)
  2. Whereas all option strikes that are lower than the ATM strike are classified as In The Money (ITM).

 

NSE distinguishes In The Money (ITM) options by displaying them with a pale yellow background, while Out of The Money (OTM) options are indicated by a regular white background. This visual differentiation helps traders quickly identify the status of different options on the platform. Considering the spot is at 8060, the intrinsic value for 7500 strikes is 560 and a mere 60 in case of 8000 – higher intrinsic value indicating deeper moneyness of the option. This makes 7500 strike an ‘Deep In the Money’ option and 8000 as just ‘In the Money’ one.

I’d suggest you take a look at the premiums listed in the green box. Can you spot any trends? Going from Deep ITM to Deep OTM, the premium decreases – basically, ITM options will always be pricier than OTM options.

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