Let’s continue talking about options. Before we dive into the strategies involving options, and options trading, I will introduce terminology that options’ practitioners use every day to talk about their investments. So when you talk about your investments, you will be on top of your game!
You can also watch my video “How To Trade Options: Moneyness and Intrinsic Value” on my YouTube’s channel. Check it out!
You will learn what out-of-the-money, at-the-money, and in-the-money options are. You will discover the graph of options before the maturity, and what the intrinsic value and the time value of an option are.
Those are the building blocks of options strategies you can use to make money in the stock market. For example, a straddle, which is a common strategy, involves buying calls and puts, both at-the-money. A related strategy called a strangle, involves buying calls and puts, both out-of-the-money. So you see those concepts are important, and you must understand them before we talk about the strategies involving options.
In my last video about options, “Options: Trade and win! Understand how options work!” I showed you the profit and loss profile of call and put options, both when you buy and sell them. I also introduced what the strike price is, and all the basic concepts you need to understand to start trading. I also briefly talked about the risks and rewards involved in buying and selling options. Check it out if you did not see it!
I will talk about options on a non-dividend-paying stock, but the same concepts apply to options on anything, like options on an index, or options on interest rates.
The intrinsic value of an option.
The intrinsic value of an option is the value you get if you could exercise the option immediately. We do not care if the exercise style is American or European.
So what does it mean?
Intrinsic value of a call option
If you have a call, and the stock price is higher than the strike price, if you exercise it immediately, you will get a positive cash value.
Remember the call option value, at maturity or when you exercise it early, is equal to the higher between the stock price less the strike price, and zero. If the stock price is over the strike, the difference is positive and it is the intrinsic value. If the stock price is lower than the strike, the difference is negative, so the intrinsic value is zero because zero is higher than any negative number.
Intrinsic value of a put option
In the case of a put, if the stock price is lower than the strike price, if you exercise it immediately, you will get a positive cash value.
The put option value, at maturity or when you exercise it early, is equal to the higher between the strike price less the stock price, and zero. The subtraction is flipped if you compare it to the call. So if the stock price is under the strike, the difference is positive and it is the intrinsic value. If the stock price is higher than the strike, the difference is negative, so the intrinsic value is zero because zero is higher than any negative number.
You already knew what intrinsic option is!
Did you see what I did? In my last post about options, and so far in this one, I only showed you the intrinsic value of options. So you knew all along what it was, without knowing the word for it.
One word of caution here, the intrinsic value does not depend if you are the option buyer or seller. We are not talking about profit or loss. If you sold a put, and the stock goes down to zero, you have a massive loss, but the option has an immense positive intrinsic value.
I am sure some people were short of Lehman Brothers’ put options just before the bank collapsed. The stock went down to zero. The intrinsic value of puts was equal to their strike price. And put sellers had an awful day.
Since you now understand the intrinsic value, you will see that the moneyness of an option is a straightforward concept.
Out-of-the-money, at-the money, and in-the-money options
Each time the intrinsic value is positive, we say the option is in-the-money. Each time the intrinsic value is equal to zero, the option is out-of-the-money, with one exception. If the strike price and the stock price are equals, the intrinsic value is zero, but we say that the option is at-the-money. An at-the-money option becomes in-the-money or out-of-the-money as soon as the stock price moves.
If you buy and sell options, you will call options whose strikes are around the stock price as being at-the-money. The at-the-money moneyness is, in fact, a tiny zone around the stock price.
Do you remember, I said I am talking about options on non-dividend paying stocks. Why? Because for a dividend-paying stock, you should remove the dividends’ present value to get the at-the-money strike. Options do no give you the right to receive a dividend; this is why the at-the-money strike should be adjusted. When a stock pays a dividend, its price goes down by the value of the dividend.
Let me know in the comments below if you want me to explain it in more details.
Moneyness and options’ chain
Let’s see in the options’ chain of Tesla, where are the different moneyness.
For calls, any strike over the stock price is out-of-the-money. Around the stock price, we have the at-the-money calls. And for all strike prices below the stock price, we have the in-the-money calls.
For puts, it is the reverse. Any strike below the stock price is out-of-the-money. Around the stock price, we have the at-the-money puts. And for all strikes over the stock price, we have the in-the-money puts.
The time value of options
The last subject of this video is the time value of options.
Before maturity, the price of an option is higher than the intrinsic value .
This extra value over the intrinsic value is called the time value of the option. It depends on multiple factors. First, how long the option will remain alive? Secondly, what are the expected movements during the remaining life of the option? And third, how high are the interest rates? The two most significant factors being usually the first two ones.
More the maturity or expiration date is in the future, higher is the time value. It makes sense since you let extra time for your option to be valuable instead of being worthless. And the more time you have, more the stock may move further in a favorable direction.
The second major factor is what are the expected movements of the underlying asset during the remaining life of the option. How an asset moves is called volatility, and embedded in the option’s price is what all market participants expect the volatility will be in the future. This is called implied volatility.
Higher is the implied volatility; higher is the time value and the option price. Because when a stock is highly volatile, you may end up with a lot of money if it moves sharply in a direction that favors you.
I practiced volatility arbitrage when I managed option portfolios. It is an aspect of options that I love, even if it is way out of the scope of this post.
So we are done, now you know everything on the options’ moneyness, the intrinsic and time values.
Next time I will start talking about strategies involving options you can use! I want to provide actionable financial education! Let me know in the comments how I am doing so far. I do believe that personal finance is more than just talking about credit cards or real estate. I want you to be able to invest not only in real estate and the stock market but also to know how to trade options. If you want me to talk more about how to invest in the stock market for beginners, let me know in the comments section.
Question of the day: did you invest using options before? What were the biggest challenges you had to start using options?