If you have seen Dan Passarelli do one of his presentations, there is probably a good chance you heard him mention ?moneyness?. In fact, he even has a section about it in his books.
Moneyness isn?t a word, is it? It won?t be found on spell-check, but moneyness is a very important term when it comes to learning to trade options. There are three degrees, if you will, of moneyness for an option, at-the-money (ATM), in-the-money (ITM) and out-of-the-money (OTM). Let?s take a look at each of these terms, using tech behemoth Apple (AAPL) as an example. At the time of writing, Apple was hovering around the $115 level, so let?s define the moneyness of Apple options using $115 as the price.
At-the-Money
An at-the-money AAPL option is a call or a put option that has a strike price about equal to $115. The ATM options (in Apple?s case the 115-strike put or call) have only time value (a factor that decreases as the option?s expiration date approaches, also referred to as time decay). These options are greatly influenced by the underlying stock?s volatility and the passage of time.
In-the-Money
An option that is in-the-money is one that has intrinsic value. A call option is ITM if the strike price is below the underlying stock?s current trading price. In the case of AAPL, ITM options include the 110 strike and every strike below that. One will notice that option positions that are deeper ITM have higher premiums. In fact, the further in-the-money, the deeper the premium.
A put option is considered ITM when the strike price is above the current trading price of the underlying. For our example, an ITM AAPL put carries a strike price of 120 or higher. As with call options, puts that are deeper ITM carry a greater premium. For example, a February AAPL 125 put has a premium of $12.85 compared to a price of $9.25 for a February 120 put.
If an option expires ITM, it will be automatically exercised or assigned. For example, if a trader owned a AAPL 110 call and AAPL closed at $115 at expiration, the call would be automatically exercised, resulting in a purchase of 100 shares of AAPL at $110 a share.
Out-of-the-Money
An option is out-of-the-money when it has no intrinsic value. Calls are OTM when their strike price is higher than the market price of the underlying, and puts are OTM when their strike price is lower than the stock?s current market value. Since the OTM option has no intrinsic value, it holds only time value. OTM options are cheaper than ITM options because there is a greater likelihood of them expiring worthless.
If this is the case, why purchase OTM options? If you have little investing capital, an OTM option carries a lower premium; but you are paying less because there is a higher possibility that the option expires worthless. OTM options are attractive because OTM calls can see their premium increase quickly. Of course, OTM options could see their premium decrease quickly as well. Remember that OTM options can log the highest percentage gain on the same move in the underlying, in comparison to ATM or ITM options.