Moneyness – Key Points About Selling Options Part 4
Moneyness – Key Points About Selling Options (Part 4)
Some key terminology, a couple slides here on that, before we get into strategy because I’m going to reference these terms ‘in the money’, ‘at the money’ and ‘out-of-the-money’. Certainly, may have heard of these before. One thing I’ll say about that is ‘in the money’, the description from the buyers perspective, an option is in the money if the option holder owns the right to execute a transaction and shares of stock at a better price than currently available in the open market. In the case of call options, and ‘in the money’ option means the strike price is below the stock. The option holder who has the right to buy shares at $40 with the stock price trading at $50 has an ‘in the money’ option and then you can further calculate how much is it ‘in the money’ and that would be by $10 in my example.
‘Out of the money’ for calls means the strike price is higher. There is no ‘in the money’ amount. It’s ‘out of the money’ and you can also calculate how far is it ‘out of the money’, but there’s no value there. There’s no inherent value, and for put options it’s the opposite. Same definition, the owner of a put option who has the right to execute a stock transaction at a better price than the open market will give him is an ‘in the money’ option. But, for puts that means the strike is higher. The owner of an $80 strike put option with the stock trading at $70 owns the right to sell shares ten dollars higher than the open market value or open market stock price. That would be an ‘in the money’ option by $10 and for ‘out-of-the-money’ the strike prices for put options are lower than the stock price.
The moneyness, whether it’s ‘in the money’, ‘at the money’ or ‘out of the money’ really has nothing to do with profit. There isn’t a direct relationship there. There’s an indirect one, if a call buyer purchases a strike price that is ‘out of the money’ they want that option to become ‘in the money’. They want the stock to move in their favor, so it moves up the chain of moneyness and becomes an ‘in the money’ option and continues to grow in its intrinsic value.
The change in status has something to do with it, but just the fact that an option becomes ‘in the money’ does not mean that a trade is profitable. Profit is simply calculated as the difference between what you bought an option for and what you sold it for. This is important to understand because it helps calculate intrinsic value and time value, which is essential when you’re evaluating the construction of a position or when you’re managing a position that you have moving forward that will become clear.
Examples of strategies that I go through are going to be very simple, but I’ll try to highlight these elements, because doing this calculation on moneyness intrinsic value and time value is very important, because sometimes there’s a clear position management technique that you would be aware of if you’re doing this type of analysis.