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Professional Trading through Option Theory

Lesson -> Option contract - Moneyness concept

  1. The basics of call option
  2. The Option Jargons
  3. Call Option - Buying
  4. Call option -Selling/Writting
  5. Buying the Put Option
  6. Selling the Put option
  7. Call & Put Option - Summary
  8. Option contract - Moneyness concept
  9. Delta - 'The option Greek' Section -1
  10. Delta - Section 2
  11. Delta - Section 3
  12. Gamma - Section 1
  13. Gamma - Section 2
  14. Concept of 'Theta"
  15. The Basics of Volatility
  16. Calculation of Volatility (Historical )
  17. A study to Volatility and Normal Distribution
  18. Application of Volatility
  19. Vega - Basics
  20. Understanding the Greek Interaction
  21. A Guide to 'Greek Calculator'
  22. Re-calling Call & Put Option
  23. Bringing to a conclusion
  24. Physical Settlement

8.1 -What is Intrinsic Value?

An option contract's moneyness is a method of classifying each strike (option) as one of three options: In the money, At the money or Out of the cash. This classification allows the trader to choose which strike to trade based on a market situation. But before we get into details, it is worth reviewing the concept of intrinsic values again.

If an option buyer has the right to exercise the option at any time, the intrinsic value of the option is the amount of money he makes from the options contract. The intrinsic value of an option is always positive and cannot be lower than 0. Take this chart as an example.
(chart)

 

Assume you purchased the 8050CE. Instead of waiting 15 days for the expiry date, you could exercise your option today. Let me ask you a question: How much money could you make if you exercised your contract today?

Remember that when you exercise a long-term option, the amount you make is equal to the intrinsic value of the option less the premium paid. To answer the above question we must calculate the intrinsic value for an option. For this we will need to use Chapter 3's call option intrinsic value formula.

Here's the formula:

Intrinsic value of a call option
= Spot price - Strike price

Let's plug in the values

= 8070-8050

= 20

If you exercise this option now, you can make 20 points, but you will not be able to claim the premium.

Below is a table that calculates the intrinsic value of various options strikes (these are not random values that I used to illustrate the concept).
(chart).
 

I trust you now have a clear understanding of the intrinsic value calculation for each option strike. Here are some important points:

  1. The intrinsic value is the money you would make if the option was exercised.
  2. An option contract's intrinsic value cannot be negative.it can be positive or zero.
  3. Call option Intrinsic Value
    = Spot Price – Strike Price
  4. Option Intrinsic Value
    = Strike Price – Spot price

Let's close this discussion by asking you: Why do you believe that the intrinsic value can never be negative?

Let's take an example from the table above to answer the question. Strike is 920, spot is 918 and option type (long call) is the one that is being used. Let's assume that the premium for the 920 call option is Rs.15.

Now

  1. What would you get if you exercised this option?
    1. We get the intrinsic value.
  2. What is the intrinsic value of the property?
    1. Intrinsic Value = 918-920 = -2
  3.    Based on the formula,we will get -Rs.2. What does this signify?
    1. This means that Rs.2 will be taken from our wallet
  4. This is what we can believe for a second; how much will it cost?
    1. 15 + 2 = Rs.17/ -
  5. We know that the maximum loss for call option buyers is limited to how much premium they pay. In this instance, Rs.15/-
    1. Negative intrinsic worth means that the property of option payouts is not respected (Rs.17/loss as opposed to Rs.15 /-). Hector should ensure that the intrinsic worth of the option payout is not negative to preserve the nonlinear property.
  6. The same logic can be applied to the calculation of intrinsic value for put options

This should hopefully give you an insight into why an option's intrinsic value cannot go negative.

8.2 - What is 'Moneyness' in a Call Option?

After our discussion on the intrinsic value, moneyness should be easy to understand. The moneyness of an option is a classification that determines the value of each strike based on how much money a trader would make today if he exercises his option contract. There are three main categories.

  1. In the Money (ITM).
  2. The Money (ATM).
  3. Out of the Money (OTM).

For practical purposes, it might be best to further categorize them as -

  1. Deep in the money
  2. In the Money (ITM).
  3. The Money (ATM).
  4. Out of the Money (OTM).
  5. Deep Out of the Money

It is easy to understand these options and classify strikes. Simply determine the intrinsic value. If the intrinsic value of the option strike is not zero, it is called 'In the Money'. The option strike is called "Out of the Money" if the intrinsic value is zero. The strike closest to the Spot price is called "At the Money".
(image 1)

 

The image shows that the strike prices available for trade start at 7100 and go up to 8700.

First, we will identify "At The Money Option (ATM]" as this is the easiest option to work with.

We know that ATM option refers to an option strike that is close to the spot price. The spot price is 8060 so the closest strike would be 8050. If there was an 8060 strike then 8060 would be the ATM option. In the absence of 8060 strikes however, ATM is the next closest strike. We therefore classify 8050, as the ATM option.

Once we have established the ATM option (8050), it is time to identify ITM or OTM options. We will select a few strikes to calculate the intrinsic value.

  1. 7100
  2. 7500
  3. 8050
  4. 8100
  5. 8300

Keep in mind that the spot price for strikes is 8060.

@ 7100

Intrinsic Value = 8060-7100

= 960

Strike should not have a zero value.

@7500

Intrinsic Value = 8060-7500

= 560

Strike should not have a zero value.

@8050

This is the ATM option, as the 8050 strike is close to the spot price 8060. We won't bother to calculate its intrinsic worth.

@ 8100

Intrinsic Value = 8060-8100

= - 40

The intrinsic value of a negative intrinsic value is therefore 0. The strike is Out of Money (OTM) since the intrinsic value for this strike is 0.

@ 8300

Intrinsic Value = 8300 - 8060

= - 240

The intrinsic value of a negative intrinsic value is therefore 0. The strike is Out of Money (OTM) since the intrinsic value for this strike is 0.

You may already be aware of the generalizations (for calls options), but let me reiterate the same.

  1. OTM is for all option strikes higher than the ATM strike
  2. All strikes below the ATM strike are ITM

Actually, I suggest that you take a second look at the photo we just posted.

(IMAGE 2
 

NSE offers ITM options with a pale background. All OTM options have regular white backgrounds. Let's now look at two ITM options: 7500 and 8000. Given that the spot is at 8160, the intrinsic value of each option works out to 560 and 60 respectively. The option's moneyness is determined by its intrinsic value. Higher values indicate that it is more valuable. 7500 strikes are considered a 'Deep in the Money' option, while 8000 is just an 'In-the-money' option.

You should look at the premiums for each of these strike prices (highlighted green box). Is there a pattern? As you move from the 'Deep ITM" option to the 'Deep OTM' option, your premium will decrease. ITM options are generally more expensive than OTM options.

8.3 -What is Moneyness in a Put Option?

Let's do the same exercise again to see how strikes are classified for put options as OTM or ITM. This is a snapshot of the various strikes that are available for a put option. The blue box highlights the strike prices. Please note that Nifty's spot price is 8 May 2015.



(IMAGE 3).
 

There are many strike prices, ranging from 7100 up to 8700. First, we will classify the ATM option. Next, we'll identify the OTM and ITM options. The ATM option should be the closest strike to the spot, as it is located at 8202. The above snapshot shows that there is a strike at 8200, which trades at Rs.131.35/+. This is the ATM option.

Now, we will pick some strikes that are above and below the ATM to figure out ITM or OTM options.Further, we will take these strikes and evaluate their intrinsic value respectively(Moneyness)

  1. 7500
  2. 8000
  3. 8200
  4. 8300
  5. 8500

@ 7500

The intrinsic value of a put option can be calculated using Strike-Spot.

Intrinsic Value = 7500-8200

= - 700

OTM is the best option because it has negative intrinsic value.

@ 8000

Intrinsic Value = 8000-8200

= -200

OTM is the best option because it has negative intrinsic value.

@8200

8200 is already a ATM option. We will therefore skip this step and continue.

@ 8300

Intrinsic Value = 8300-8200

= +100

Positive intrinsic value is the reason ITM is an option

@ 8500

Intrinsic Value = 8500-8200

= +300

Positive intrinsic value is the reason ITM is an option

Therefore, a simple generalization of Put options is -

  1. All strikes that are higher thanATM options will be considered ITM.
  2. All strikes lower thanATM options will be considered OTM

As you can see, ITM options have premiums that are significantly higher than OTM options.

You should now have a better understanding of how option strikes can be classified according to their moneyness. You may be still pondering about why you need to classify options according to their moneyness. The answer lies again in "Option Greeks". Option Greeks, which are market forces that act on options strikes and affect the premium associated to these strikes, are what you already know. A market force that has a specific effect on ITM options will also have an effect on OTM options. This will allow us to better understand the Option Greeks' impact on premiums by classifying them.

8.4 - Creating The Options Chain

Most trading platforms and exchanges have the option chain as a standard feature. The option chain can be used to identify all strikes available for an underlying. It also helps you classify strikes based upon their moneyness. The option chain provides additional information, such as the premium price (LTP), bid price, volumes, open interests, and so on. Each option strike is listed below.

Take a look at the Ashoka Leyland Limited option chain as published on NSE.
(IMAGE 4).

 

These are a few observations that will help you better understand the options chain.

  1. The underlying spot price is Rs.68.7/– (highlighted in blue).
  2. The call options are located on the left side the option chain
  3. The Put options can be found on the right side in the option chain
  4. In the middle of the option chain, the strikes stack in an increasing order
  5. The closest strike to the spot at Rs.68.7 is 67.5. This would make it an ATM option (highlighted yellow).
  6. For Call options, all strike levels lower than ATM options are ITM options. They have a pale yellow background
  7. For Call options, all options strikes greater than ATM options are OTM options. They have a white background.
  8. For Put Options, all strike options higher than ATM are ITM options. They have a pale yellow background.
  9. All options strikes that are lower than ATM for Put Options are OTM options. They have a white background.
  10. NSE's pale yellow background and white background are used to segregate the OTM and ITM options. This is not a common convention.

 

8.4 - The Progression

We are now able to explore the options more deeply, having both understood the basic call and put options from the sellers and buyers perspectives, as well as the concepts of OTM, ITM and ATM.

Next chapters will focus on understanding Option Greeks and their impact on option premiums. We will use the Option Greeks effect on premiums to determine the best strike to trade in a given market situation. We will also look at the 'Black & Scholes Option pricing formula' to understand how options are priced. The 'Black & Scholes Option Pricing Formula will help us understand why Nifty 8200 PE trades at 131, not 152, or 102.

I hope that you find as much excitement to read about these topics as I am about writing about them. Please stay tuned.

Now, onwards to the Option Greeks!

Keypoints

  1. The intrinsic value is equal to the amount of money that the option buyer would make if he exercised the contract.
  2. The intrinsic value of an option can't be negative. It is a positive, non-zero value.
  3. Spot Price - Strike price = intrinsic value of call option
  4. Strike Price - Spot price is the intrinsic value of a put option.
  5. Option with an intrinsic value (ITM) is a category.
  6. Option without intrinsic value (OTM) is a option.
  7. If the strike price is close to the spot price, the option can be considered as an 'At-the-money' (ATM option).
  8. All strikes below ATM are ITM options (for calling options).
  9. OTM options (for calls options) are available for strikes that exceed ATM.
  10. All strikes greater than ATM are ITM Options (for Put options).
  11. OTM options (for put options) are available for strikes that are lower than ATM.
  12. It is known as the 'Deep IITM' option when the intrinsic value of the stock is extremely high.
  13.    Similarly,when at the list,the intrinsic value ,is termed to be 'Deep OTM'Option  
  14. Premiums for ITM options will always be higher than those for OTM options.
  15. The Option chain allows you to quickly visualize which option strike is OTM, ITM, ATM (for both calls or puts), and other relevant information about options.