05) Moneyness

by · January 5, 2015

In options trading you’ll hear these phrases a lot: “in the money”, “at the money” and “out of the money”. These are what is known as “moneyness”.

They all refer to the relationship between…

  • The strike price
  • The current price of the underlying stock.
  • and Whether it’s a call option or a put option

 

What does “In the Money” mean?

To explain this very simply, “in the money” calls means that the given strike price of the calls is less than the current underlying stock’s price.

Calls – In the Money (ITM)

strike price < underlying stock price
For example: $630 calls are in the money because the stock is
trading at $639.70

 

Puts – In the Money (ITM)

strike price > underlying stock price
For example: $650 puts are in the money because the stock is
trading at $639.70

What does “Out of the Money” mean?

“Out of the money” calls means that the given strike price of the calls is greater than the current underlying stock’s price.

Calls – Out of the Money (OTM)

strike price > underlying stock price
For example: $650 calls are out of the money because the stock is
trading at $639.70

 

Puts – Out of the Money (OTM)

strike price < underlying stock price
For example: $630 puts are out of the money because the stock is
trading at $639.70

What does “At the Money” mean?

“At the money” refers to both call and put contracts where the strike price is very close to or the same as the underlying stock price.

Which “Moneyness” Should I Trade?

To answer this question, let’s take a look at the major differences between “in the money” and “out of the money” contracts.

Since options pricing is greatly dependant upon the probability that the underlying stock price will be “in the money” at the time of expiration, if the call or put contract that you are purchasing is “in the money” now, there is a greater probability that it’ll be “in the money” later.

This causes the price per contract to increase as you choose a strike price more and more “in the money”

…and decrease as you choose a strike price less and less “in the money”

…and decrease even more as the strike price is more and more “out of the money”.

Here we can look at an underlying stock that is trading at $639.70.

  • calls at a strike of $630 = most expensive (and most in the money)
  • calls at a strike of $635 = more expensive (and more in the money)
  • ————————————–
  • calls at a strike of $640 = less expensive (and more out of the money)
  • calls at a strike of $650 = least expensive (and most out of the money)
  • puts at a strike of $630 = least expensive (and most out of the money)
  • puts at a strike of $635 = less expensive (and less out of the money)
  • ————————————
  • puts at a strike of $640 = more expensive (and more in the money)
  • puts at a strike of $650 = most expensive (and most in the money)

The more “in the money” you go with your strike price…

  • The lesser the risk potential and the lesser the reward potential and, the greater the cost per contract

 

 

The more “out the money” you go with your strike price…

  • The greater the risk potential and the greater the reward potential and, the lesser the cost per contract