Lessons from the Pros


Options for Newbies – Happy Can’t Buy Moneyness

This is another in our series called Options for Newbies. In this series, I’m explaining options from the ground up. Even if you’re a veteran, these articles may give you a deeper understanding of some aspects of options than you had before.

In options, there is an important concept called “moneyness.”  It’s central to our understanding of options.

At any moment in time, every option is said to be either “IN the money,” “OUT of the money,” or “AT the money.”  This “moneyness” has nothing to do with anyone’s profit or loss.  It refers strictly to the relationship between the strike price of the option on the one hand, and the current price of the underlying asset on the other.

In our original example, which you can read about here, we talked about September options to buy Apple stock at $650 per share. At the time, the stock was trading around $673. Those $650 calls would have let us buy the stock at a $23 discount ($673 – $650).  Put another way, if we somehow got those options for free, we could have exercised them and bought the stock for $650; then immediately sold the stock on the open market for $673.  If so we would have made $23.  So $23 is the amount by which those options were in the money. We say they were “$23 in the money,” or “in the money by $23”.  We also say that they had intrinsic value of $23. Intrinsic value is the amount by which an option is in the money, if any.  This in-the-money amount, or intrinsic value, changes second-by-second as the stock price changes. At any given moment, it is the amount of money we could make if we got the options for free, exercised them at that moment, and then instantly liquidated the resulting stock position.

Put options, which are options to sell an underlying asset at a specific strike price, also may be in the money, and therefore may have intrinsic value. At the time of our Apple example, there were also September Put options to sell Apple at $650 (as well as put options at many other strike prices). Anyone who owned the $650 puts had the right to “put the stock to” someone at $650, which means to forcibly sell it to someone and extract $650 per share from them. Who is it who would have to pay $650 for Apple, even if had dropped to $600, or $500, or zero? The people who had sold the puts – they would have no choice. That’s what the sellers of puts sign up for when they sell them.  (By the way, the poor put sellers didn’t have to wait for this to happen to them.  They could have bought their way out of their obligations earlier, by re-purchasing the puts they had sold, although possibly at a loss).

In this case, anyone who had sold $650 puts made out well. Since Apple was at $700 when the puts expired, no one exercised the $650 puts.  Why not? Because options give their owners the right to exercise them, but not the obligation to do so.  They can exercise them, but they don’t have to.  If exercising an option would cause a loss instead of a profit, no one will exercise it. When these $650 put options expired, anyone who owned them and wanted to sell Apple could do so on the open market at $700. Why would they sell it for less? They wouldn’t.  They’d just throw away the $650 put options like a losing lottery ticket, and sell the Apple stock for $700.

So those $650 put options were out of the money at expiration.  Because they were out of the money, they had no intrinsic value. Since they were expiring, there was no more time, so they had no time value, either.  In fact they had no value at all.  We say they “expired worthless” or “went out worthless.” Anyone who owned these puts lost whatever they had paid for them.  Anyone who sold the puts profited by the full amount that they had received, and their obligation disappeared upon expiration.

There were, of course, other September put options that were in the money when they expired.  Which ones? Any with strike prices above $700 (Apple’s price at the close on expiration).  The $710 put options were in the money by $10; therefore had intrinsic value of that same $10; and in fact sold at the close for almost exactly $10.  The $720 puts were worth $20, the 730’s were worth $30, and so on.  Anyone who owned any of these in-the-money puts at expiration owned something of value.  Whether they made a profit is a different question. Anyone who owned the $710 puts had something worth $10 (per share, or $1,000 per 100-share contract).  If they bought the puts for less than $10 they made a profit; if they paid more than $10, they didn’t.  Once again, there were plenty of people who had paid more and many who had paid less than $10.

So here are the rules in a nutshell:

  1. Calls are IN the money when the stock is above their strike price.
  2. Calls are AT the money when the stock is at their strike price.
  3. Calls are OUT OF the money when the stock is below their strike price.
  4. Puts are IN the money when the stock is below their strike price.
  5. Puts are AT the money when the stock is at their strike price.
  6. Puts are OUT OF the money when the stock is above their strike price.
  7. Options that are IN the money have intrinsic value equal to the amount by which they are in the money.
  8. Options that are at the money or out of the money have zero intrinsic value.
  9. All options’ value consists of their intrinsic value (if any), plus their time value (also called extrinsic value).
  10. The value of all out-of-the-money options consists of nothing but time value.
  11. When there is no time, there is no time value, therefore
  12. At expiration, all at-the-money and out-of-the-money options go out worthless; and all in-the-money options are worth exactly their intrinsic value.

That’s it for this issue. If you have questions or comments, contact me at rallen@tradingacademy.com

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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