Option Money: Review, Options and Values – Carswellfamilyfoundation

“At the money,” “at the money,” and “out of the money” are commonly used terms for an option. moneynessunderstanding the intrinsic value of these derivative contracts.

This article discusses the basic concepts of money, which also relate to option valuation and trade.

Key Findings

Moneyness describes the intrinsic value of an option’s premium in the market.
At-the-money (ATM) options have an exercise price exactly equal to the current price of the underlying asset or stock.
Out-of-the-money (OTM) options have no intrinsic value, only “time value” and occur when the call strike is above the current market or the put strike is below the market.
In-the-money (ITM) options have intrinsic value, meaning you can exercise the option immediately for the opportunity to profit, i.e. if the call option strike is lower than the current market price or the put option strike is higher.

Overview: Elements of Option Pricing

As a basic overview, we will consider a typical version. quote which will contain the following information:

Name underlying asset – i.e. ABC Corp. shares
Expiration date – i.e. December 2020
Strike price – i.e. 400.00
Class – i.e. call vs put
Price – i.e. option premium

The price of an option contract is called option premiumthat is, the amount of money that the buyer of an option pays to the seller for the right, but not the obligation, to exercise the option. This should not be confused with strike pricethat is, the price at which a particular option contract can be sold. carried out.

These elements work together to help you determine moneyness option – a description of the intrinsic value of an option, which is related to its exercise price, as well as to the price of the underlying asset.

Intrinsic value and time value

The option premium can theoretically be divided into two components:

Intrinsic value involves a simple calculation: just subtract market price from the exercise price, which represents the profit that the option holder would receive if he exercised the option, took delivery of the underlying asset, and sold it in the current market.

Time value is then calculated by subtracting the intrinsic value of the option from the option premium.

Options “in the money”

Let’s see how money behaves. For example, let’s say it’s September and Pat long (i.e., she owns) the December 400 call option on ABC Corp. The option has a current premium of 28 and ABC is currently trading at 420. The intrinsic value of the option would be 20 (market price 420 – strike price 400 = 20). Therefore, the option premium of 28 consists of $20 intrinsic value and $8 time value (option premium 28 – intrinsic value 20 = 8).

Pat’s option is in the money. An in money (ITM) An option is an option that has some intrinsic value. Regarding call optionThis is an option with a strike price below the current market price. It would make the most financial sense for Pat to sell her call option because she would receive $8 more per share than by taking delivery and selling the shares on the stock exchange. open market. For a put option, which gives the holder the right to sell shares at a specified price, intrinsic value will exist if the strike price is above the market price, allowing you to sell the shares for more than they are worth and buy them back. below.

Deep-in-the-money options present lucrative opportunities for traders. For example, buying a deep-in-the-money call option can provide the same dollar profit opportunity as buying an actual stock, but with a smaller capital investment. This results in much higher profits. Selling deep-in-the-money covered calls gives the trader the opportunity to make some profit immediately rather than waiting until the underlying stock is sold. It can also be profitable when a long stock becomes overbought, as this will result in an increase in intrinsic value, and often time value, due to increased volatility.

Out-of-the-money options

Returning to our example, if Pat had instead been long the December 400 ABC. put option with a current premium of 5, and if the current market price of ABC were 420, it would have no intrinsic value (the entire premium would be considered time value) and the option would be no money (OTM). An out-of-the-money put option is an option with a strike price below the current market price.

The intrinsic value of a put option is determined by subtracting market value from the execution price (exercise price 400 – market value 420 = -20). Intuitively, it looks like the intrinsic value is negative, but in this scenario, the intrinsic value can never be below zero.

At-the-money options

A third scenario could be that the current market price of ABC was 400. In this case, the call and put options would be at the money (ATM)and the intrinsic value of both options here would be zero, since immediate exercise of either option would not result in any profit. However, this does not mean that options have no value, since they will still have time value.

The Importance of Time Value

Time value is the main reason that few options are exercised in practice, but a significant number closing, compensatorycovering and selling shares or contracts. In our example, Pat would have increased her profit by 40% ($8/$20) by selling a call option instead of taking delivery of the stock and selling it. 8 dollars cover speculation which exists for the ABC price from September until it expires in December.

This part of the premium is determined by the market, but it is not a random estimate. Many factors play a role in determining the time value of an option. For example, Black Shoals The option pricing model is based on the interaction of five separate factors:

Price of the underlying asset
Option strike price
Standard deviation of the underlying asset
Time until expiration
Risk-free rate

Bottom line

Understanding options pricing basics it is part science and part art. It is vital to understand where profits come from and what they represent in order to maximize your profits from options trading. Anyone trying to determine the moneyness of an option may find it helpful to work through some of the best online brokers for options trading.

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