Option moneyness: at-the-money, in-the-money, out-of-the-money

By roma, 17 August, 2020

At-the-money

An option is called “at-the-money” when the strike is equal to the forward price of the underlying asset. For example, if stock is trading at $35 and the interest rate is 0%, then call and put options with a strike price of $35 are at-the-money. At-the-money options do not have intrinsic value, but only consist of time value. Most transactions on the options market are carried out precisely around ATM options.

The term “at-the-money” refers to one of three terms describing the relationship between the strike price of an option and the forward price of the underlying asset (the spot price if the interest rate is zero), which is also called the option's moneyness. The other two terms are “out-of-the-money” and “in-the-money”.

 

In-the-money

A call option with a strike price lower than the forward price of the underlying asset and a put option with a strike price higher than the forward price are called in-the-money options. In-the-money option has both intrinsic and time value. If the option is in-the-money at the time of expiry, its value is determined as follows:

ITM Call = Closing price of the underlying asset - Strike price
ITM put = Strike price - Closing price of the underlying asset

For example, consider an Apple share that is trading at $132. For simplicity of calculations, let's assume that the risk-free interest rate is zero and the share does not pay dividends. For an Apple stock, all call options with strike prices below $132 are in-the-money, and put options with strike prices above $132 are also in-the-money.

Due to the fact that option trading is about trading volatility, not the direction of the price of the underlying asset, traders rarely deal with ITM options. This is due to the higher value of ITM options relative to at-the-money and out-of-the-money, which requires more capital but does not increase risk or income.

 

Out-of- the-money

A call option is called out of the money (OTM) if the strike price is higher than the forward price of the underlying asset. A put option is out of the money if the strike price is lower than the forward price. The price of the out of the money option consists only of the time value and has no intrinsic value. Therefore, as the expiry date approaches, the value of the out-of-the-money (OTM) option falls to zero.

For example, consider a share that is trading at $20. For simplicity of calculations, the interest rate and dividend yield are 0%. For such a stock, all call options with strike prices above $20 are out of the money, and put options with strike prices below $20 are out of the money too.

Due to the fact that OTM options have no intrinsic value, their price is much lower than the price of at-the-money and in-the-money options.