Explain what an option's moneyness means
The idea
An option is in the money when exercising it immediately would produce a positive payoff, at the money when the underlying sits at the exercise price, and out of the money otherwise. For a call, in the money means the underlying is above the exercise price; for a put the relation reverses. Moneyness describes only the intrinsic component - an out-of-the-money option still has a positive price whenever time remains, because the underlying may yet move. Moneyness is therefore a statement about where the underlying is now, not about whether the option is worth anything.
A practice question
When is a call in the money?
- When the underlying is above the exercise price - correct
- When the underlying is below the exercise priceWhy not: That is when a put is in the money, and when a call is worth abandoning.
- When the premium exceeds the intrinsic valueWhy not: Positive time value is typical of options with time remaining, whether in or out of the money, so it does not identify moneyness.
A call gives you the right to buy at the exercise price. It is in the money when that right is worth something now, which means the underlying is trading above the exercise price. Call intrinsic value = max(S − X, 0). Example: strike 50, underlying 55. You can buy at 50 something worth 55, so the call is in the money by 5. A put is the reverse: its right to sell is valuable when the underlying is low.
A harder one
Why does an out-of-the-money option still trade at a positive price?
- Because exchanges set a minimum priceWhy not: Exchanges set tick sizes, not values. A genuinely worthless option would trade at the minimum tick and attract no buyers.
- Because the writer must be compensated for marginWhy not: Margin is a cost to the writer, but the option's value comes from what it might become worth.
- Because time remains for the underlying to move into the money - correct
An out-of-the-money option has no value if used right now. But it still has time left, and the underlying price could move in your favour before expiry. People will pay something for that chance. Option price = Intrinsic value + Time value. Intrinsic value is what the option is worth if used now, here zero. Time value is the price of the chance of a favourable move, so it is positive. At expiry no time is left, so time value is zero and the price falls to intrinsic value.
The hardest tier
A call and a put on the same underlying share an exercise price of 80, and the underlying trades at 80. What is true of their moneyness and intrinsic values?
- Both are at the money, with zero intrinsic value - correct
- Both are in the moneyWhy not: In the money requires intrinsic value, and at the strike both have none.
- The call is in the money and the put is out of the moneyWhy not: That would require the underlying to be above 80. At exactly 80 neither has any intrinsic value.
At the money means the underlying price equals the exercise price. Here both are 80. Call intrinsic value = maximum of (80 − 80, 0) = 0. Put intrinsic value = maximum of (80 − 80, 0) = 0. So neither option is worth anything if used now. Their prices are made up only of time value (the chance of a favourable move), so while time remains both still trade at positive prices.
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