In the last few articles I?ve described the factors that effect the amount of time value in an option. Previously I discussed the impact of crowd expectations (aka implied volatility), and the march of time toward expiration. Today we?ll look at the effect of ?moneyness? on time value.
These short articles are designed to help give you a basic understanding of the workings of options, to help you decide if you want to pursue the subject further. Do not attempt to trade them without an actual education!
Moneyness is the relationship of an option?s strike price to the current strike price of the underlying asset. If any cash flow could be realized by exercising an option today, and then liquidating the resulting stock position, then we say the option is ?in the money.? Otherwise it is ?out of the money.?
For example, today IBM closed at $185.80. Any call options with strike prices lower than that would enable the owner to buy IBM at a discount to that $185.80 price. So the call options with strike prices at $185, $180, etc. were ?in the money.? All call options with strike prices higher than $185.80, say at $190 or $195, were ?out of the money.?
Note that this ?moneyness,? the property of being in the money or out of the money, has nothing to do with anyone?s profit or loss, and is independent of the amount paid for the option. It describes nothing but the relationship of stock price and strike price.
If a call?s strike price is far below the current strike price, say at $160 in the IBM example, then we say that option is ?deeply in the money.? If its strike price is far above the current stock price, then we say that the option is ?far out of the money.? We can?t say the options are ?deeply out of the money,? although some people mistakenly do. An IBM call at a strike price of $225 would be far out of the money.
Options whose strike prices are right at the current stock price are said to be ?at the money.? By convention, we refer to the options whose strike prices are closest to the current price as being ?the at the money option,? even if the stock price is not exactly at the strike. In the IBM example, the option strikes are $5 apart. There are options at $185 and $190, but not at $185.80. The $185 options in this case are referred to as the at-the-money options, because they are the closest to the current $185.80 price.
An option?s status as being in, out of, or at the money is not permanent. It changes as the stock price moves. Today the $180 calls are in the money. Tomorrow IBM could drop down to $175. The 180 calls would then be out of the money.
The amount of time value in an option is heavily influenced by how far in or out of the money it is. The best way to understand this is to think of time value as a measure of the uncertainty about an option?s status being changed by stock price movement. If there is a high likelihood that an out of-the-money option can become in the money, then it will have a large amount of time value. But if it were so far out of the money that there was almost no chance of its ever getting into the money, then it would have little or no time value. Likewise, an in-the-money option whose strike is very close to the current stock price has a pretty strong chance of ending up out of the money. It too will have a lot of time value. But, strangely, if it were so far in the money that it was very unlikely to become out of the money, it too would have very little time value.
Here are some of the call prices, and their time value, in our IBM example:
Note the bold row above. The $185 calls, with $2.40 of time value, have far more than the $190 calls do. The $185 calls, currently in the money by $.80, could pretty easily get pushed out of the money in the remaining time in their life. IBM just has to drop by $.80. For the $190 calls to switch sides, however, would take a much bigger move. IBM would have to move up by $4.20. Since a $4.20 move (in any direction) is much less likely in any set time than an $.80 move, the time value in the 190 calls is much less ? just $1.10 compared to the $2.40 of time value in the 185?s.
Switching our attention to in-the-money options: the $175 calls are much more expensive than the $185 calls ($11.27 vs $3.20). Yet almost all of that $11.27 consists of intrinsic value. These much more expensive options have only $.47 of time value, compared to the $2.40 in the $185?s. This reflects the smaller amount of uncertainty. For the 175 calls to become out of the money, IBM would have to drop over $12. Since that is very unlikely to happen in the option?s lifetime, their time value is not worth much either.
To summarize:
For any given expiration date, the options with the highest time value are the at-the-money options. The farther an option?s strike price is from the current strike price ? in either direction ? the less time value it has.