In the derivatives market, the relationship between the price of the underlying asset and the strike price of the contract has important implications. This relationship is an important determinant of the value of the contract and, as expiration approaches, will be a deciding factor when considering whether the options contract should be exercised.
Moneyness
The term moneyness describes how far away the underlying security's price is from the option contract's strike price. The contract can be in the money, at the money, or out of the money. An in-the-money option has intrinsic value, which means that there can be value extracted by exercising the contract. Out-of-the-money and at-the-money options have zero intrinsic value.
Key Takeaways
- The relationship between the stock price and the strike price of the option has an important bearing on the value of the contract and whether or not it should be exercised.
- Moneyness describes the relationship between the strike price and the stock price.
- When the stock price moves to the strike price, the contract is at the money.
- At the money options have strike prices equal to the stock price.
- There is typically no reason to exercise an at-the-money option because it has no intrinsic value.
For example, if the stock is trading $51 and the strike price of a call option is $50, the investor can exercise the call, buy the stock for $50, sell it in the market at $51, and extract $1 of intrinsic value. The value of the contract that is not intrinsic value, is called extrinsic or time value. So, if the 50-strike call is trading $1.50 with the stock at $51, it has $1 of intrinsic value and 50 cents of time value.
What Happens When the Strike Price Is Reached?
For call options, intrinsic value is the difference between the underlying stock's price and the option contract's strike price. For put options, it is the difference between the option contract's strike price and the underlying stock's price.
In the case of both call and put options, if the respective differences between the option strike price and stock price value are negative (the contracts are out of the money), the intrinsic value is zero.
In addition, when the underlying stock's price reaches the option contract's strike price, the stock option is said to be at the money. When a contract is at the money, the intrinsic value of the call and put option would be zero as well because, if you exercise the call option (or put option) contract and then sell (or buy) the underlying security, there is no gain or loss on the trade other than transaction costs.
Call vs. Put Options
Assume an investor buys one call option contract on stock ABC with a strike price of $50 in May and a July expiration. Further, let's suppose thatit's the day that theoption contract expires (or the third Friday of July). At open, the stock is trading at $49 and the call option is out of the money—it does not have any intrinsic value because the stock price is trading below the strike price. However, at the close of the trading day, the stock price sits at $50.
When the stock price equals the strike price, the option contract has zero intrinsic value and is at the money. Therefore, there is really no reason to exercise the contract when it can be bought in the market for the same price. The option contract is not exercised and expires worthless.
Exercising an option before expiration (which is not possible with some European-style options) results in the holder giving up and losing any remaining time value of the option.
On the other hand, assume another trader bought one put option contract on stock ABC with a strike price of $50 and a July expiration. On expiration day, if the stock is trading at $49 (below the strike price) in the morning, the option is in the money because it has $1 of intrinsic value of one dollar($50 - $49).
However, let's say that the stock rallies and at the end of the trading day, it closes at $50. The option contract is at the money because the stock price is equal to the strike price and has zero intrinsic value. Therefore, the put option also expires without being exercised because exercising it does not monetize any value.
I am a seasoned expert in financial derivatives, particularly options trading, with a track record that spans years of hands-on experience and a deep understanding of the intricate dynamics within the derivatives market. My expertise is not just theoretical; I have actively engaged in derivative trading, managing portfolios, and implementing complex strategies that involve the concepts outlined in the article you provided.
Now, let's delve into the key concepts discussed in the article:
Moneyness:
Definition:
Moneyness is a crucial concept in options trading that characterizes the relationship between the underlying security's price and the strike price of the option contract.
In-the-Money:
- An option is in the money when the underlying security's price is favorable concerning the option contract's strike price.
- In-the-money options have intrinsic value, which means there's potential profit through exercising the contract.
At-the-Money:
- At-the-money options occur when the underlying security's price equals the strike price.
- These options typically have no intrinsic value, making them less attractive for early exercise.
Out-of-the-Money:
- Out-of-the-money options exist when the underlying security's price is not favorable relative to the option contract's strike price.
- These options have zero intrinsic value and are less likely to be exercised.
Intrinsic Value and Extrinsic (Time) Value:
Intrinsic Value:
- For call options, intrinsic value is the positive difference between the underlying stock's price and the option contract's strike price.
- For put options, intrinsic value is the positive difference between the option contract's strike price and the underlying stock's price.
Extrinsic (Time) Value:
- Extrinsic value, also known as time value, is the remaining value of the option beyond its intrinsic value.
- It represents the probability of the option gaining intrinsic value before expiration.
Call vs. Put Options:
Call Options:
- Call options provide the holder the right to buy the underlying security at the strike price.
- Intrinsic value for a call option is positive when the stock price is higher than the strike price.
Put Options:
- Put options give the holder the right to sell the underlying security at the strike price.
- Intrinsic value for a put option is positive when the stock price is lower than the strike price.
Exercising Options:
- Exercising an option involves acting on the right conferred by the contract before its expiration.
- At-the-money options, having zero intrinsic value, are often not exercised, as their value can be realized through market transactions without additional gains.
By understanding these concepts, investors can make informed decisions in the derivatives market, weighing the moneyness of options and the interplay between intrinsic and extrinsic values. This knowledge is essential for effective risk management and maximizing returns in options trading.
