Moneyness is a foundational concept in finance that describes the relationship between an underlying asset's current price and the strike price of a derivative contract, typically options. This relationship determines whether an option possesses intrinsic value and helps traders evaluate potential profitability. Understanding moneyness is essential for making informed trading decisions and managing risk effectively.
What is Moneyness?
Moneyness classifies options into three primary categories based on their strike price relative to the underlying asset's spot price:
- In the Money (ITM): The option has positive intrinsic value if exercised immediately.
- At the Money (ATM): The option's strike price is equal to the underlying asset's current price.
- Out of the Money (OTM): The option has no intrinsic value if exercised at the current price.
This classification can be further refined by using the asset's forward price (a price agreed upon today for future delivery) instead of the spot price, leading to terms like "at the money forward" (ATMF).
Key Definitions
- Call Option: A contract giving the holder the right to buy an asset at a specified price.
- Put Option: A contract giving the holder the right to sell an asset at a specified price.
- Strike Price: The predetermined price at which the option can be exercised.
- Spot Price: The current market price of the underlying asset.
- Forward Price: The agreed-upon price for a future transaction.
The Three States of Moneyness
In the Money (ITM)
An option is in the money if exercising it immediately would generate a profit.
- A call option is ITM when the underlying asset's spot price is above the strike price. The intrinsic value is calculated as Spot Price - Strike Price.
- A put option is ITM when the underlying asset's spot price is below the strike price. The intrinsic value is calculated as Strike Price - Spot Price.
ITM options have both intrinsic value and time value. Their price is significantly influenced by movements in the underlying asset's price.
At the Money (ATM)
An option is at the money when the strike price and the spot price of the underlying asset are identical. ATM options have no intrinsic value—their entire premium consists of time value. These options are highly sensitive to changes in the underlying asset's price, time decay, and shifts in implied volatility.
Informally, options with strike prices very close to the spot price are often called near the money or close to the money.
Out of the Money (OTM)
An option is out of the money if exercising it immediately would result in a loss; it has no intrinsic value.
- A call option is OTM when the spot price is below the strike price.
- A put option is OTM when the spot price is above the strike price.
OTM options consist solely of time value. They are cheaper to purchase than ITM options but are also less likely to expire profitably. 👉 Explore more strategies for evaluating OTM options
Intrinsic Value vs. Time Value
An option's total premium is composed of two parts:
Intrinsic Value: The tangible, real value of an option if it were exercised immediately. It is zero for ATM and OTM options and positive for ITM options.
Time Value (Extrinsic Value): The portion of the option's premium that exceeds its intrinsic value. It represents the premium paid for the potential future price movement of the underlying asset before expiration. Time value decays as the expiration date approaches, a phenomenon known as time decay.
For American-style options (which can be exercised early), it is rarely optimal to exercise an option that still has time value, as you would be forfeiting that remaining value.
Quantifying Moneyness
Beyond the basic three-state classification, moneyness can be quantified into a numerical value to measure how far an option is in or out of the money. This is crucial for building volatility surfaces, which plot implied volatility against moneyness and time to expiry.
Common measures of moneyness include:
- Simple Moneyness: The ratio of the spot (or forward) price to the strike price (S/K or F/K). An ATM option has a simple moneyness of 1.
- Log Simple Moneyness: The natural logarithm of the simple moneyness (ln(F/K)). This linearizes the measure, making ATM equal to 0.
- Standardized Moneyness: This advanced measure normalizes the log moneyness by both the time to expiration and the asset's volatility. It tells you how many standard deviations the forward price is from the strike price.
The most theoretically precise measure of moneyness is derived from the Black-Scholes model. The variable d₂ in the formula represents the risk-neutral probability that the option will expire in the money. 👉 Get advanced methods for calculating probability-based moneyness
Practical Example of Moneyness
Let's assume stock XYZ is currently trading at $100 per share.
| Option Type | Strike Price | Moneyness | Reason |
|---|---|---|---|
| Call Option | $90 | In the Money (ITM) | Spot ($100) > Strike ($90) |
| Put Option | $90 | Out of the Money (OTM) | Spot ($100) > Strike ($90) |
| Call/Put Option | $100 | At the Money (ATM) | Spot ($100) = Strike ($100) |
| Call Option | $110 | Out of the Money (OTM) | Spot ($100) < Strike ($110) |
| Put Option | $110 | In the Money (ITM) | Spot ($100) < Strike ($110) |
Frequently Asked Questions (FAQ)
What is the difference between spot moneyness and forward moneyness?
Spot moneyness compares the strike price to the current market price. Forward moneyness compares the strike price to the agreed-upon future price (forward price) of the asset. Forward moneyness is often preferred in theoretical models as it accounts for the time value of money and cost of carry.
Can an option's moneyness change over time?
Absolutely. Moneyness is not static. As the price of the underlying asset fluctuates, an option can move from being OTM to ITM, or vice versa. This change is a primary driver of an option's price volatility.
Why are ATM options often the most actively traded?
ATM options have the highest sensitivity to changes in the underlying asset's price (known as Gamma) and implied volatility (Vega). This makes them attractive for traders speculating on short-term price movements or volatility shifts, rather than a pure directional bet.
Is a higher Delta always better for an ITM option?
A higher Delta (closer to 1.0 for calls or -1.0 for puts) means the option's price will move almost penny-for-penny with the underlying asset. While this is good for capturing gains, it also means the option was more expensive to purchase initially. The optimal Delta depends on an investor's strategy, risk tolerance, and capital.
How does time decay affect different moneyness states?
Time decay (Theta) affects all options, but its impact is most pronounced on ATM options because their value is purely time value. The time value of deep ITM and deep OTM options decays at a slower rate as expiration approaches.
What does "deep in the money" or "deep out of the money" mean?
These are informal terms describing the degree of moneyness. A "deep ITM" call option has a strike price far below the spot price, giving it a high intrinsic value and a Delta near 1.0. A "deep OTM" option has a strike price far from the spot price, a very low Delta, and a low probability of expiring profitably.
Conclusion
Moneyness is a critical lens through which traders view and value options. It provides an immediate snapshot of an option's intrinsic worth and its potential for future profitability. By understanding the core concepts of ITM, ATM, and OTM, as well as the more nuanced quantified measures, investors can make more strategic choices about which options to buy, sell, or hold based on their market outlook and risk profile. Mastering moneyness is a fundamental step toward advanced options trading and effective risk management.