Hey everyone, this is Kirk here again at OptionAlpa.com and in this video we're going to talk about
option moneyness or the difference between in the money, out of the money and at the
money options.
We're also going to talk a little bit about extrinsic versus intrinsic value.
Options are generally classified by traders into three very distinct categories, in the
money options, ITM, at the money options, ATM and out of the money options, or OTM.
These are also used to quickly reference difference options when building complex option strategies.
You'll often see, especially in our ultimate strategy guide and in all of the different
video tutorials and modules we have at Option Alpha that we will more often than not reference
buying an in the money option and selling an out of the money or buying an at the money,
selling at the money or whatever the case is.
We use these a lot as traders to quickly talk about a section or a group of trades based
on where they are in the option pricing table.
Let's go through an example here with a simple call option.
This is a call option pay off diagram, probably one you've seen before in this track as we've
been doing other videos.
For call options there's a lot of different moneyness related to where the stock price
is because again, everything in moneyness is determined based on the strike price and
its relationship to the stock price.
In this case if we have a 40 strike call option, that's where the payoff diagram pivots, this
is a 40 strike call option.
The option would be in the money is the stock price was higher than the strike price.
If the strike price or if the stock price was higher than the strike price, then this
option would be in the money.
In this case if the stock price was $50 and we had the 40 strike options, we would be
in the money.
When I always think of in the money versus out of the money, in the money means am I
making money or am I not, right?
That's the way I always distinguish it is if I'm in the money, I'm making money, meaning
the stock price is higher than my strike price.
For an option that is at the money, then the stock price is going to be equal to or very
similar to the strike price.
An at the money option in this example would be a 40 strike call when the stock is trading
at $40 or something very, very close to 40.
An out of the money option would be when the stock price is dramatically below the option
strike price.
Again, these are just for a call option.
In this case this would be when the stock price is at $30 and we are buying an out of
the money 40 strike call where the strike price is above the current stock price.
Again, the way I always think about it is an out of the money because I'm not making
money yet.
My option isn't in the money at expiration.
It's not making money yet.
Another quick way to look at it is visually on a chart.
In this case if we have the current stock price at let's say $45 which is the difference
here in these shaded areas.
If we see the stock trading from 45 down to 40, okay, then that strike price is in the
money because the strike price down here at 40 with the stock trading at 45 means that
we've got a $5 difference between our strike price and where the stock is trading at $45.
That strike price at 40 is in the money.
It's making money right now.
We can buy stock at 40 and sell it back at 45.
If later on we look at a strike price of $45 which is exactly where the stock is trading
right now and exactly where the strike price is, that strike price is at the money.
It's basically the strike price exactly where the stock is trading right at the moment.
A strike price that's out of the money would be an example of a strike price around $50.
Again, kind of using the same numbers that we used before.
If the stock is currently trading at 45 and we buy a 50 strike call option, then that
strike is out of the money.
It's above where the market is trading currently.
We need the stock to rally before we actually make any money at expiration.
All right, so let's flip things over here and look at an example with a put option.
Now a put option is going to be pretty much everything just in reverse.
A put option that's in the money, meaning they're making money, is when the stock price
is now below where the strike price is.
In this case if we have the 40 strike put options, we'd be in the money if the current
stock price was $30 and if we had the 40 strike put options, those would be in the money because
they'd be making money based on the current stock price of $30.
If we had an at the money put option, obviously the strike price and the stock price would
be very similar or the same.
This would be a $40 strike price and a $40 stock price.
If we had an out of the money put option, that means that the stock price is much higher
than the current strike price.
If the current stock price was $50 and we wanted to trade the 40 strike puts, those
40 strike put options would be out of the money or below where the stock is trading
right now.
Okay?
Here's the thing, before we get into some examples on my live thinkers from platform,
pricing for options is basically put into two components.
There's really two main components that make up pricing.
There's intrinsic value and then there's extrinsic or time value for an option contract.
I'm going to show you how we can actually see the differences between those for every
contract that you want to look at.
It's important to realize that an option with intrinsic value is in the money and does have
value at expiration.
That's how we determine intrinsic value is we basically ask ourselves if expiration was
today could you make money on this option?
If the answer is yes, then it's an in the money option.
If the answer is no, then it's an out of the money option and usually at the money options
are either just slightly in or just slightly out of the money.
Okay?
Let's look again at a couple of examples here.
We're going to go back to our option pricing table here with DIA.
We've used this one in a couple other videos inside of this beginner track here at Option
Alpha.
Again, just to refresh your memory, we've got all of the strike prices right down here
in the middle and then we've got the call options on the left hand side and we've got
the put options on the right hand side.
Now I've adjusted these actual columns to show you intrinsic and extrinsic value because
this is going to help us understand which options are in the money and which options
are out of the money.
Now the first thing we have to realize is that DIA right now is trading at 176.07.
Now this is going to move because this is all live, real-time pricing.
It's trading at 176.0708, so a couple pennies above 176.
Let's start on the call side of the options pricing table.
Now it's really cool here because Think Or Swim does a really good job and most broker
platforms do, they usually shade any call options that are in the money.
They might shade them a different color, but you can see that really with a call option
any strike price that is below where the current stock price is is going to have an option
that is in the money on the call side.
Now you can see all of these options, 174s, then 174.5, 175, et cetera, et cetera.
These are all in the money right now on the call side because the options strike price
is below where the current stock price is.
You'll notice that the 176.5 call options are not shaded here and that is because those
options are just slightly out of the money.
Those options are just slightly out of the money.
The at the money options in this case would be the 176s, because they are the closest
to where the stock is trading right now.
Again, it will never be exactly perfect.
You'll probably rarely see a stock trade right out at round number all the time, but it's
always going to be the strike prices that are closest to where the stock is trading
currently.
In our case with DIA it's the 176 calls inputs.
That's the at the money strike.
Now again, on the call side the out of the money options are the ones that are not shaded.
These are the ones with strike prices that are higher than where the stock is currently
trading right now.
DIA is trading at 176.
All of these strike prices are above or higher than 176.
That means that all of these options are OTM or out of the money.
If we ever talk about selling at out of the money or buying an out of the money, we're
talking about these options on the left hand side.
If we use the put side now and go over to the other side of the pricing table you can
see everything is now in reverse because put options and call options basically trade in
reverse, meaning that everything with a strike price now above where the stock is trading
are options on the put side that are in the money.
They're all shaded yellow here.
These are all in the money options.
You'll notice now the 76 option in the put side is out of the money versus being just
slightly in the money on the call side.
Now you can see that that's the difference.
Again, these, this shading will change as the value and as the price of the underlying
stock changes.
As it goes up and as it goes down most broker platforms will show you the difference between
these.
Again, these options over here, these are all in the money, ITM.
These options down here, these are all out of the money, or OTM on the put side and visa
versa on the call side.
Now in both of these categories we have these extrinsic and intrinsic value.
Now remember what we said about intrinsic value.
Intrinsic value is the value if expiration were to come today, meaning how much money
could you make owning these options if expiration came today and you had no choice but to buy
and sell the stock as required by the option contract?
In this case you look at something like the 176 call options and you can see that the
intrinsic value is basically the difference between the current stock price and the strike
price, that's 176.
The current stock price is 176.13.
If the market were to end today and expiration were to come today, we could theoretically
buy stock at 176, sell it back at 176.12 or 176.13 and that's where we come up with our
intrinsic value of 12 cents for this contract.
Again, this is going to move.
Intrinsic value is always going to move penny for penny with where the stock is and it's
basically going to show you how much money you could make at expiration if everything
were to end today.
Okay?
Now notice any out of the money options have no intrinsic value.
That means you would never exercise your contract to buy a 176.5 stock and then be able to sell
it for 176.11.
You would never buy stock willingly for more than you could sell it for at the same time.
That's why you'll see all out of the money options on both sides have zero intrinsic
value.
There's no value to those at expiration.
That's why they expire worthless at expiration, because eventually the value of options always
goes towards intrinsic value.
That's what happens.
They go always towards intrinsic value as they near expiration.
Now extrinsic value is a combination of time decay and volatility and a little bit of dividend
and interest rate pricing for options.
Extrinsic value shows you the additional value of that contract based on how much time is
left and how much volatility is in the market.
This is where we really start to talk about our edge in trading because extrinsic value
can fluctuate very, very fast without the stock actually moving.
As implied volatility rises extrinsic value across the board rises as well.
All option values rise when implied volatility rises.
Just like all option values drop when implied volatility drops.
The stock does not have to move.
In this case it's showing you that let's take the 176.5 call options here.
Those options right now are priced between 185 and 190, but all of that value of those
options is extrinsic value, meaning all of the value of those contracts right now is
based on the assumption that there's time and volatility that those contracts may at
some point in the future increase in value to some intrinsic value.
Okay?
You'll notice that as you go further and further out of the money the value of options goes
down because there's a low likelihood that those options become in the money.
Right?
The options that are close like the 176.5, those options have a pretty good shot of being
in the money, meaning there's a pretty good shot that that DIA trades from 176.15 up to
and above 176.5.
There's a less likelihood that it trades up to 179.
The value of those options in their extrinsic value format is much, much lower than the
176.5 because there's a lower likelihood that DIA trades up to 179.
Okay?
This concept of intrinsic and extrinsic value is very, very important, especially as we
talk about how options are priced, how prices move and how prices fluctuate with different
changes in the market and now we're starting to develop hopefully a good solid foundation
as we move further into track one and kind of towards the back half of track one in talking
about option strategies, how to choose those and options pricing and why our edge is mainly
surrounded by implied volatility.
Again, thank you so much for checking out this video tutorial.
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Until next time, happy trading.