FAMILIARIZING OPTION MONEYNESS
Moneyness is one of the most important aspects of option pricing. It pertains to the intrinsic value of an option in its present state relative to its strike price and the underlying asset’s price.
There are two factors accounted when determining the moneyness of an option: quote and premium. Option quote is comprised of the name of the underlying asset, strike price, class, and expiration date. Option premium is the amount of money the buyer pays to the seller to obtain the right, not obligation, to exercise the derivative.
The option premium is divided into two parts: intrinsic value and time value. Getting an option’s intrinsic value is simple, just subtract its market price from its strike price. The result is the profit a holder would gain if he or she decides to exercise the option, delivered the underlying asset, and sold it. Time value is the intrinsic value minus option premium.
For example, Reni is long on Expedia Inc. (NASDAQ: EXPE) June 400 call option, with a premium of 28 and trading at 420. Its intrinsic value would be 20. The option premium of 28 has $20 of intrinsic value and $8 of time frame. On that note, Reni is on the money, an option with intrinsic value. When it comes to a call option, this is an option in which the strike price is less than the current market price.
Let us say Reni goes long on June 400 put option, having a premium of 5. She would not obtain any intrinsic value if the prevalent market price of EXPE is 420. Therefore, the option would be out of the money, an option with a strike price lower than the current market price. For put options, the intrinsic value is calculated by deducting the market value from the strike price. The intrinsic value, although the outcome is lower than zero, can never be negative.
Assuming the present market price of EXPE is 400, both the call and put options would be at the money, and expect the intrinsic value to reach zero. Exercising either option won’t lead to any profit, but the option still has time value.
In case there is little exercising of options and several offsetting, covering, closing out, and selling of contracts, attribute it to time value. Another thing: Time value is affected partly by premium. Various factors appear when establishing the time value of an option. The Black-Scholes option pricing model pointed out the five factors affecting its time value: underlying asset’s price, strike price, underlying asset’s standard deviation, risk-free rate, and expiration date.
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