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The Moneyness For Calls And Puts When Trading Stock Options

Filed Under Beginner Options Trading 

Table 1-4 describes the moneyness for calls and puts:
 
Table 1-4
Call Options
Moneyness
Relationship to Stock
In-the-money
Stock price > Strike price
At-the-money
Stock price = Strike price
Out-of-the-money
Stock price < Strike price
 
Put Options
Moneyness
Relationship to Stock
In-the-money
Stock price < Strike price
At-the-money
Stock price = Strike price
Out-of-the-money
Stock price > Strike price
 
Most option exchanges, such as the CBOE, always provide at least one in-the-money and one out-of-the-money option for each month. This means that as the stock moves to new highs (or lows) then new strikes will be added to each expiration month.
 
The moneyness of an option affects the amount of time premium present. In general, in-the-money and out-of-the-money options will have the smallest time premiums. At-the-money options have the greatest amount of time premium. In other words, at-the-money options contain the highest amount of time value, and that value shrinks as we move toward the in-the-money or the out-of-the-money strikes.
 
The at-the-money option has the highest time value. Time value shrinks as we move in-the-money or out-of-the-money.
 
For example, Table 1-5 shows the time values for the July calls and puts in Table 1-1:
 
Table 1-5
Strikes
Call Time Value
Put Time Value
$32.50
0.29
0.20
$35
0.59
0.50
$37.50
1.05
1.01
$40
0.35
0.31
 
Notice that the time values are relatively small for the in-the-money strikes ($32.50 call, $35 call, $40 put). The time values are also relatively small for out-of-the-money strikes ($40 call, $32.50 put, $35 put). It is the at-the-money strike ($37.50) that has the highest time value. Figure 1-6 shows the intrinsic and time values for only the call options in Table 1-4. You can see that the time value is very small for the $32.50 call because it is so far in-the-money. As we increase the strike price, the time premium gradually increases as well until we’re only left with pure time premium.
 
Figure 1-6

Figure 1-6

 
 
Parity
An option that is trading for purely intrinsic value (i.e., no time value) is trading at parity. For instance, assume that the underlying stock is trading for $46. If the $40 call is trading for $6 then it is comprised totally of intrinsic value and is therefore trading at parity. Options generally only trade at parity when there is little time remaining (usually a matter of hours).
 
 
Wasting Assets
We’ve learned that if you want a call or put option you must pay money for it. We also know that options expire at some time and that leads to an interesting question. Do options lose all of their value at expiration? After all, if the option is no longer good, how can it have any value?
 
While it is true that an option loses some of its value with each passing day, there is often a big misconception about how much of that premium is lost at expiration. There are traders who will tell you that all options become worthless at expiration, and that is simply not true. In an earlier section “Intrinsic Values and Time Values,” we said that all options must be worth at least their intrinsic value – and expiration time is no different. At expiration, all options lose only their time value but not their intrinsic value. It is only the time value portion of their price that slowly bleeds away with time. The intrinsic value remains intact. This is one of the reasons why it is so important to understand how to decompose an option into its intrinsic and time values. Certain strategies rely on the use of intrinsic values, while others make use of the time values. If you want to trade, hedge, or invest with options, you need to know how much of each value is present at each strike price.
 
To make sure you understand this concept, let’s look at the August $35 call in Table 1-1, which is trading for $3.60. We know there is $37.11 - $35 = $2.11 worth of intrinsic value and that means that the remaining value, or $3.60 - $2.11 = 1.49 worth of time value. If you were to buy this call and eBay closed at the same price of $37.11 at expiration, the $35 call would still be worth the intrinsic value of $2.11. It would not be worth zero. The only amount you would lose is the $1.49 worth of time premium. Remember, traders are paying the additional $1.49 over and above the immediate value because there is time remaining. Once time is gone (option is expired), then there can be no time value on the option, but the intrinsic value will remain. In Figure 1-6, the intrinsic value is bold and the time value is shaded. It is only the shaded portion that erodes with time. (Bear in mind this doesn’t mean that you cannot lose the intrinsic value. However, that value can be lost due to adverse stock movement only and not the passage of time.)
 
Because options lose some value with each passing day, they are called wasting assets. There are some traders who reject the use of options since part of the option’s price deteriorates simply by the passage of time, but that is a thoughtless reason. The car you drive loses value over time. The same is true for the fruits and vegetables you buy. What about the computer you use? It doesn’t make sense to say that it’s not worthwhile to invest in assets whose value depreciates over time. You just have to be careful in the way you use them. Nearly all assets deteriorate over time, so don’t back away from options just because a portion of their value depreciates over time. Even the expensive factories that General Motors, Dell Computer, or Intel have built all lose value with each passing day, but the CEOs will tell you they have been very productive assets.
 
Time Decay
Time decay does not occur in a straight line over time. In other words, an at-the-money option with 30 days to expiration does not lose 1/30 of its value each day. Instead, it loses value slowly at first, which then progressively accelerates more and more each day. This is called exponential decay. Figure 1-7 shows the price of a 90-day option where we assume that nothing changes except the passage of time. You can see the rapid acceleration of decay as time gets near expiration – especially in the last thirty days.
 
Figure 1-7
 

Figure 1-7

 
Some texts will show this chart in the reverse order with the numbers on the horizontal axis increasing from 0 to 90, which is probably more mathematically correct since the numbers are ascending as we move left to right. However, it makes it awkward to read since you must make time move from right to left as we approach expiration. It’s usually easier for people to visualize time moving forward by moving from left to right. It’s a matter of preference as to which type of chart you use. Just realize that as you continue reading about options that you may encounter time decay charts that appear backwards but it’s just due to two different styles of presenting the same concept. The important point is that you understand that time decay is not linear. Because of this, it is usually to your advantage to buy longer periods of time and sell shorter periods of time. We will revisit this concept later but just realize for now that an option’s value does not decay in a straight line.
 
Before we leave this section, you might be wondering if there are any similarities between stocks and options. You might be surprised that options are similar to stock in many ways.
 
To be continued……..

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