Moneyness Definition and Intrinsic Value of Options

What is Moneyness?

Moneyness is a description of a derivative relating its strike price to the price of its underlying asset. Moneyness describes the intrinsic value of an option in its current state. The term moneyness is most commonly used with put and call options and is an indicator as to whether the option would make money if it were exercised immediately. Moneyness can be measured with respect to the underlying stock or other asset's current/spot price or its future price.

Breaking Down Moneyness

Moneyness tells option holders whether exercising the option will lead to a profit. Types of Moneyness include include in, out or at the money. Moneyness looks at the value of an option if you were to exercise it right away.

In the Money

An option that has moneyness is in the money. In other words, exercising that option would result in a profit.

For example, if you have a call option to buy shares in XYZ at $40 and XYZ currently trades at $45, your option is in the money because you could exercise it to buy shares at a discount. The higher the market price for a share compared to the strike price of a call option, the more in the money that option is.

If you have a put option, the market price for the share must be below the strike price of the option for it to be in the money. In this scenario, you could buy shares and immediately exercise the option to sell them for a profit.

At the Money

When an option has no moneynes, meaning that you would neither make or lose money from exercising it, that option is said to be at the money.

For both call and put options, this occurs when the market price for a share and strike price for the option are equal.

Out of the Money

An option is is out of the money when it has no moneyness, meaning you would lose money by exercising it.

For example, if you have a call option to buy shares in XYZ at $50, but the shares currently trade at $45, you'd wind up paying more for each share if you exercise the option. A call option gets more out of the money as the market value of a share falls further below the option's strike price.

Put options become out of the money when the market value of a share is higher than the strike price because you would make more by selling shares on the open market than by exercising the option.

Understanding Intrinsic and Time Value of Options

The value of an option is made up of two components: intrinsic value and time value.

Moneyness is used to describe intrinsic value. This is the financial value that the option provides were you to exercise it today. You can calculate it simply by determining the moneyness of the option.

For calls, use this formula:

$Market Price - Strike Price = Intrinsic Value of a Call$MarketPrice−StrikePrice=IntrinsicValueofaCall

For puts, use this formula:

$Strike Price - Market Price = Instrinsic Value of a Put$StrikePrice−MarketPrice=InstrinsicValueofaPut

In both cases, you can multiply by the number of shares involved in the options contract, which is typically 100.

Time value is the other determinant of an options contract's value, and it is harder to quantify.

Options have an expiration date. When this date arrives, the option expires and can no longer be exercised, but up until that date, you can exercise American Type options at any point. Stock prices change on a daily basis. The more time there is before an option expires, the more opportunity there is for the moneyness, or intrinsic value, of the option to increase.

That means that the time value of an option is higher if there is more time until the contract expires. Time value reduces over time until the expiration date, when time value reaches $0.

Why Understanding Moneyness is Important

Understanding moneyness is important when trading options for the simple reason that moneyness makes up half of an options contract's value with time value being the other half of the equation.

If you know about moneyness, you can look at an option's price and quickly determine how much of its price is determined by the intrinsic value of the option and what the time value of that option is.

You also need to understand moneyness to understand what needs to happen for you to profit from an options trade. For example, if you expect a share to rise, you can buy an out-of-the money call option and hope that it becomes in the money.

If you opt for more complicated options strategies, understanding moneyness is also key for figuring out your total risk.

The Bottom Line

An option is in-the-money, or has moneyness, when exercising it would generate a profit. That means that the underlying stock's price is higher than the strike price for a call option. The reverse is true for a put option. to be in-the-money, the strike price would be higher than the stock's price.

Understanding moneyness is key to understanding the intrinsic value of options, which is used in the formula for calculating an options contract's value.