Options Greeks

Options Moneyness

Understanding options moneyness is essential before diving deeper into options trading strategies. This lesson provides a comprehensive review of how the relationship between an option’s strike price and the underlying asset’s current price determines its moneyness classification and affects its value.

The three primary classifications are At the Money (ATM), In the Money (ITM), and Out of the Money (OTM). An ATM option has a strike price equal to the spot price, and assignment at expiration is not automatic but requires written request. For call options, ITM means the strike is lower than the spot price (for example, a $49 strike when the stock trades at $50), while OTM means the strike is higher. For put options, the definitions are reversed: ITM strikes are higher than spot price, and OTM strikes are lower.

The relationship between moneyness and intrinsic value and time value reveals critical insights for traders. Deep out of the money options have little time value and little intrinsic value, with delta close to zero. When options are at the money, intrinsic value is still zero, but time value reaches its highest level due to maximum uncertainty about whether the option will expire in or out of the money. Deep in the money options have the highest intrinsic value but decreasing time value, because they essentially behave like holding the underlying asset with a delta of 100.

The lesson demonstrates how delta varies with moneyness, starting near zero for deep OTM options, increasing exponentially as it approaches ATM where uncertainty is highest, then flattening at 100 for deep ITM options. An example using a call option with a delta of 25 shows that if the underlying moves by $1, the option value changes by approximately 25 cents. The lesson also covers how dividend increases affect option values: when dividends increase, it’s equivalent to lowering the stock price, and the impact on option value can be calculated using delta.

Video Chapters

  1. 00:00 – Introduction to options moneyness
  2. 00:25 – Understanding ATM, ITM, and OTM definitions
  3. 03:01 – Option valuation and moneyness relationship
  4. 04:41 – Delta profile across different moneyness levels
  5. 05:31 – Speed of delta and uncertainty
  6. 06:42 – Impact of dividends on option values

Key Takeaways

  1. Moneyness represents the intrinsic value of an option and determines the relationship between strike price and spot price
  2. Time value is highest at the money due to maximum uncertainty, while both deep OTM and deep ITM options have low time value
  3. Delta varies from near zero for deep OTM options to 100 for deep ITM options, with the highest rate of change occurring at the money
  4. Dividend increases affect option values based on delta, with higher dividends equivalent to lowering the stock price
Video Transcription

[00:00:00.14] - Speaker 1
At this point, before moving forward, it is important to review the moneyness of options option. Moneyness is the relationship between the current price of the underlying asset and the option strike price. The moneyness of options is a measure of the probability that the option will have a positive monetary value at the time of its expiration. We already have introduced the concept of intrinsic value and time value. Moneyness represents the intrinsic value of an option.

[00:00:25.23] - Speaker 1
When we talk about options, we always talk about three at the Money or atm, in the Money or itm, and out of the Money or otm. These terms are used to indicate how close the strike price is from the price of the underlying security, and the definition varies depending on whether we are referring to a call option or a put option. Let's start with atm. As we already said, it stands for at the Money and is used if the strike is equal to the spot price. For example, if a stock is currently quoted at $50 and we want to buy or sell and add the Money option, it should have a strike $50.

[00:00:58.09] - Speaker 1
Whether we're talking of a call or a put, the definition is the same. When an option expires at the Money, its assignment is not automatic, but takes place only upon written request by the holder. According to the convenience, the holder of such an option is in a position of indifference at expiration. Let's look at ITM or In the Money. This is used to indicate when a strike is within the price of the underlying stock.

[00:01:21.15] - Speaker 1
The value of an in the Money option is defined differently between calls and puts. For call options, the strike is in the Money if it's lower than the spot price of the underlying asset. For example, if a stock is currently traded at $50 and in the Money, call option would have a strike of say, 49, 48, 47 or less. For put options, the strike is in the Money when it's higher than the current spot price of the underlying security. So, for example, if we wanted to buy an in the Money put on a stock that calls A$50, the strike should be 52, 53, 54, or more.

[00:01:53.18] - Speaker 1
As an example, when an option expires in the Money, its assignment is automatic. The holder is assigned a certain amount of underlying in the case of physical settlement, or it can take place by cash settlement. A similar argument also applies to the term OTM or Out of the Money, but in the opposite sense. It is used to indicate that the strike of the option is outside the price of the underlying stock. For call option, the strike is out of the Money if it is higher than the spot price.

[00:02:19.25] - Speaker 1
So if we wanted to buy an out of the money call option on a stock that currently trades at $50, the option str would need to be higher, such as 51, 54 or higher. For put option, the strike is out of the money when is lower than the spot price of the underlying security. So if we wanted to buy a put option with an out of the money strike on a security that quotes a dollar, 50, the strike should be lower, for example 49, 44 or lower. When an option expires out of the money, it is not exercise expired out of the money options are virtually worthless at expiration and their value goes to zero. So briefly summarizing While at the Money have the same definition for both calls and puts in the Money and out of the Money have opposite definitions.

[00:03:01.24] - Speaker 1
Now that we have reviewed the topic of moneyness, we can go back to talking about the option value and the relationship of moneyness with the Greeks. Let's look at the valuation of an option by looking at moneyness. If we go back to the payoff of a call option, we can see how an out of the money option has little time value and little intrinsic value. This happens because the option is very far from the at the money strike and the current spot price of the underlying. This type of option is also called deep out of the money.

[00:03:29.20] - Speaker 1
The chances of it ending up in the money are very remote. We can see that out of the money calls have a delta close to zero. If we look at the next slide, we notice two interesting things. When the option is at the money, the intrinsic value is still 0, but we are approaching a positive intrinsic value. The time value is at the highest level.

[00:03:48.09] - Speaker 1
We see it from the distance from the green line and the line of the payoff. This is due to uncertainty. When an option is at the money, the uncertainty, whether it ends up in the money or out of the money, is higher. This is why the time value is so high. Here we see what happens when the option is in the money.

[00:04:04.28] - Speaker 1
What do you notice? Intrinsic value is the highest of the three Moneyness. But this is not the most interesting point. What is important to note, however, is that when we get deep in the money, the time value that was higher at the money decreases sharply. This happens because the time value is at the highest level.

[00:04:21.15] - Speaker 1
When there is uncertainty. When we are deep in the money, as in the case of this call option, uncertainty ceases to exist. We know that when the option is deep in the money, the holder will exercise the option at expiration. This means that the Option no longer behaves like an option. From that moment, having an option in the money is equivalent to being long underlying.

[00:04:41.03] - Speaker 1
For this reason, both deep out of the money and deep in the Money options have such a low time value as there is no uncertainty anymore. Now, if we add the delta profile, we see that the delta has the largest variation when it comes to at the Money. This is for the same reason we described in the previous three slides. The delta when we are deep out of the money is zero. It increases exponentially as we approach at the Money because at this point our odds of going in the money are higher and there is more uncertainty.

[00:05:06.29] - Speaker 1
It flattens out when we are deep in the money because at that level, an option with a delta of 100 moves as if we were long the underlying asset. At this point, we can start talking about the concept of speed with regards to the delta. We will talk about this in much more detail when we introduce the concept of Gamma. But for now, we know that out of the Money and in the Money options have low speed. As we said before, this is linked to the concept of time and uncertainty.

[00:05:31.28] - Speaker 1
The delta then increases as we get closer to at the Money. Again, this is where uncertainty kicks in. When we are at the Money, we are more uncertain whether our option will finish in the Money or out of the money when it expires. When we are at the Money, then the speed of delta has the highest value for two reasons. The intrinsic value is high, but so is the time value.

[00:05:51.21] - Speaker 1
As we explained in the previous section, the highest time value is at the Money. And finally, uncertainty decreases and so does time value once we are deep in the money. Now let's look at an example to help us understand how an option can change. Based on the data, we will use a call option in this case. As we said earlier, most calls have a delta close to zero in the case of out of the Money options or close to 100 in the case of an in the Money option.

[00:06:16.17] - Speaker 1
In our example, our call has an initial delta of 25. If a call has a delta of 25, it is expected that the value of the option could change by 25% as the underlying changes. The underlying is the price of the index or a stock. So if the stock or index rises or Falls by $1, the call can be expected to rise or fall by 25 cents. At this point, it is necessary to understand a further concept linked to the movement of delta dividends.

[00:06:42.08] - Speaker 1
What we need to try to understand is how the increase in dividends affects the value of the option. Let's take a stock. When the ex dividend date comes, the stock price falls by the same amount of the dividend. But first let's try to understand what the ex dividend date is. The ex dividend date is an important date for dividend paying stocks.

[00:07:00.03] - Speaker 1
It is the date on or after which a buyer of a stock is not entitled to receive the upcoming dividend payment. The ex dividend date is set by the company and is usually a few days before the dividend distribution date. So if a company is increasing dividends in a sense is equivalent to lowering the share price. The opposite if dividends are cut. For example, if a dividend of $0.50 is expected and the dividend is increased by the company to $1, this is equivalent of lowering the stock price by another 50 cents.

[00:07:28.19] - Speaker 1
Now, since we know that the change in the value of the option based on the underlying is given by the delta, it also means that the change in the dividends can be calculated with the delta. For example, we know that if the dividend will be increased by 50 cents, a call with a delta of 70 will lose 35 cents. Here you can see how we got to 35 cents. We are now at the end of this lesson. The interesting part starts.

[00:07:50.15] - Speaker 1
Now we will talk about Greeks, Delta hedging and strategies.