Option Moneyness

Leverage & Risk

• Options can provide leverage.

• This means an option buyer can pay a
relatively small premium for market
exposure in relation to the contract value
(usually 100 shares of the underlying
stock).
• An investor can see large percentage
gains from comparatively small, favourable
percentage moves in the underlying
product.
 Leverage and Risk
• Leverage also has downside implications.
• If the underlying stock price does not rise or
fall as anticipated during the lifetime of the
option, leverage could magnify the
investment's percentage loss.
• Options offer their owners a predetermined,
set risk.
• However, if the owner's options expire with no
value, this loss can be the entire amount of
the premium paid for the option.
• An uncovered option writer may face
unlimited risk.
In-the-money, At-the-money, Out-
of-the-money

An option’s strike price, or exercise price, determines

whether a contract is in-the-money, at-the-money, or out-
of-the-money.

If the strike price of a call option is less than the current

market price of the underlying security, the call is said to
be in-the-money. (Market Price > Strike Price)

This is because the holder of this call has the right to

buy the stock at a price less than the price he would pay
to buy the stock in the stock market.
In-the-money, At-the-money, Out-
of-the-money
Likewise, if a put option has a strike
price that is greater than the current
market price of the underlying security,
it is said to be in-the-money,

because the holder of this put has the

right to sell the stock at a price greater
than the price he would receive selling
the stock in the stock market.
 Out of the Money
• The inverse of in-the-money is out-of-the-money.
• If the strike price of a call (right to buy) option is more
than the current market price of the underlying security,
the call is said to be out-the-money
• This is because the holder of this call allows the option
to expire worthless.

• Likewise, if a put (right to sell) option has a strike price

that is less than the current market price of the
underlying security, it is said to be out-the-money.
• This is because the holder of this put allows the option
to expire worthless.
 At the money
• If the strike price equals the current market
price, the option is said to be at-the-money.
Equity Call Option
• In-the-money = strike price less than stock price
• At-the-money = strike price same as stock price
• Out-of-the-money = strike price greater than stock
price
Equity Put Option
• In-the-money = strike price greater than stock price
• At-the-money = strike price same as stock price
• Out-of-the-money = strike price less than stock price
Option Premium
• Intrinsic Value + Time Value
 Factors having a significant effect
on options premium include:
• Underlying price
• Strike
• Time until expiration
• Implied volatility
• Dividends
• Interest rate
Main Components of an Option's
Premium
• An option’s premium has two main
components: intrinsic value and time
value.
Intrinsic Value (Calls)
• A call option is in-the-money when the
underlying security's price is higher than
the strike price.
 Intrinsic Value (Puts)

• A put option is in-the-money if the

underlying security's price is less than the
strike price.
• Only in-the-money options have intrinsic
value.
• It represents the difference between the
current price of the underlying security and
the option's exercise price, or strike price.
 Intrinsic Value
• The amount that an option, call or put is in-
the-money at any time is called intrinsic
value.
• By definition, an at-the-money or out-of-
the-money option has no intrinsic value.
• This does not mean investors can obtain
these options at no cost.
 Intrinsic Value
• Fluctuations in volatility,
• interest rates,
• dividend amounts and
• the passage of time
• all affect the time value portion of an
option’s premium.
• These factors give options value and
therefore affect the premium at which they
are traded.
 Time Value

• Time value is any premium in excess of

intrinsic value before expiration.
• Time value is often explained as the amount
an investor is willing to pay for an option
above its intrinsic value.
• This amount reflects hope that the option’s
value increases before expiration due to a
favourable change in the underlying security’s
price.
• The longer the amount of time available for
market conditions to work to an investor's
benefit, the greater the time value.
 Time Decay

• The longer the time remaining until an

option's expiration, the higher its premium
will be.
• This is because the longer an option's
lifetime, the greater the possibility that the
underlying share price might move the
option in-the-money.
 Time Decay

• Even if all other factors affecting an

option's price remain the same,
• the time value portion of an option's
premium will decrease (or decay) with the
passage of time.
• The intrinsic value of an option is defined as the
maximum of zero and the value the option would
have if it were exercised immediately.
• For a call option, the intrinsic value is therefore
max(S – K, 0).
For a put option, it is max (K - S, 0).
An in-the-money American option must be worth
at least as much as its intrinsic value because the
holder can realize the intrinsic value by exercising
immediately. Often it is optimal for
• the holder of an in-the-money American option to
wait rather than exercise immediately.
Payoffs from Long and Short Call
Positions
• Consider an example.
• Suppose you have a call option to buy the
stock of XY Z corporation at a strike price of K
= 100.
• What will you do on date T ?
• If the price ST of XY Z is less than 100, it is
obviously best to let the option lapse:
• There is no point paying K = 100 for a stock
that is worth less than that amount.
• The call is said to be out-of-the-money in this
case.
• If ST = 100(stock price), then you are
indifferent between exercising the option
and not exercising the option (although
transactions costs, which we ignore, may
push you towards not exercising).
• The call is said to be at-the-money in this
case.
• Finally, if ST > 100, it is very much in your
interest to exercise the call: the call allows
you to buy for 100 an asset that is worth ST
> 100.
• The call is said to be in-the-money in this
case. The profit from exercising the call is
ST −100; the higher is ST , the greater the
profits.
• What about the short position who sold you
the option?
• The short position has only a contingent
obligation in the contract; the decision on
exercise is made by buyer with the long
position.
• So to identify the payoffs to the short, we
must see when the option will be exercised
by the long position and calculate the
consequences to the short.
Long Call Pay offs / Short Call Pay
offs
Payoffs from Long and Short Put
Positions
• Consider the payoffs to a long position in a
put on XY Z stock with a strike of K = 100.
• If the price ST < 100, it is in the long position’s
interest to exercise the put;
• The put enables the long to sell for K = 100
an asset that is worth ST < 100.
• The put is in-the money in this case.
• The payoff from exercise is 100 − ST . The
lower is ST , the greater the profit from
exercising the put.
 Long Put
• If ST = 100, the long is indifferent between
exercising and not exercising the put;
• Either action leads to a payoff of zero.
• The put is said to be at-the-money in this
case.
• If ST > 100, it is obviously best to let the
option lapse: there is no point in selling for K
= 100 a stock that is worth more than 100.
• The put is said to be out-of-the-money in this
case.
 Short Put Pay offs
• The payoffs to the short position are the
reverse of the payoffs to the long;
• IfST < 100, the short position buys for K = 100
an asset that is worth ST < 100.
• The short loses 100− ST . For example, if ST =
90, the short is buying for 100 a stock worth
only 90, so loses 10. At ST = 80, the loss
climbs to 20. And so on.
• If ST = 100, the payoff to the short is zero.
• If ST > 100, the put lapses unexercised, and
the payoff to the short is once again zero.
Pay offs Long Put / Short Put