Moneyness of Option, Intrinsic Value, & Implied Volatility

Options are financial instruments that give buyers the right but not the obligation to buy or sell an underlying asset at a predetermined price and time. Options can be used to hedge against potential losses or to speculate on future price movements. Three important concepts related to options are moneyness, intrinsic value, and implied volatility. In this blog, we will discuss these concepts in detail.

Moneyness of Option:

Moneyness is a term used to describe the relationship between the strike price of an option and the current market price of the underlying asset. There are three types of moneyness: in-the-money, at-the-money, and out-of-the-money.

• In-the-money (ITM) option: An option is considered in-the-money when the current market price of the underlying asset is higher than the strike price of a call option or lower than the strike price of a put option. In this scenario, exercising the option would result in a profit. For example, if the current market price of a stock is $50 and you have a call option with a strike price of $40, the option is considered in-the-money because you can exercise the option and buy the stock for $40 and then sell it for $50 in the market, making a profit of $10 per share.
• At-the-money (ATM) option: An option is considered at-the-money when the strike price is equal to the current market price of the underlying asset. In this scenario, there is no intrinsic value in the option. For example, if the current market price of a stock is $50 and you have a call option with a strike price of $50, the option is considered at-the-money.
• Out-of-the-money (OTM) option: An option is considered out-of-the-money when the current market price of the underlying asset is lower than the strike price of a call option or higher than the strike price of a put option. In this scenario, exercising the option would result in a loss. For example, if the current market price of a stock is $50 and you have a call option with a strike price of $60, the option is considered out-of-the-money because it would not make sense to exercise the option and buy the stock for $60 when you can buy it for $50 in the market.

Intrinsic Value:

Intrinsic value is the value that an option would have if it were exercised immediately. It is the difference between the current market price of the underlying asset and the strike price of the option. In other words, it is the profit that would be made by exercising the option at the current market price.

For example, if the current market price of a stock is $50 and you have a call option with a strike price of $40, the intrinsic value of the option is $10 per share. This is because you could exercise the option and buy the stock for $40 per share, and then immediately sell it in the market for $50 per share, making a profit of $10 per share.

An option's intrinsic value cannot be negative. If an option is out-of-the-money, it has no intrinsic value. However, it may still have value in the form of time value, which is the value that an option has due to the amount of time remaining until expiration.

Implied Volatility:

Implied volatility is a measure of the expected volatility of the underlying asset based on the price of the option. It is calculated using an options pricing model, such as the Black-Scholes model. Implied volatility is an important concept because it can help traders determine whether an option is overpriced or underpriced.

If the implied volatility is high, it means that the market expects the underlying asset to be very volatile in the future. This can make the option more expensive because there is a higher chance of the option becoming in-the-money. On the other hand, if the implied volatility is low, it means that the market expects the underlying asset to be less volatile in the future. This can make the option less expensive because there is a lower chance of the option becoming in-the-money.

Implied volatility can also help traders determine whether an option is overpriced or underpriced. If the implied volatility is higher than the historical volatility of the underlying asset, it could indicate that the option is overpriced. Conversely, if the implied volatility is lower than the historical volatility of the underlying asset, it could indicate that the option is underpriced.

Traders can use implied volatility to compare the prices of options with different strike prices and expiration dates. This can help them identify options that may be undervalued or overvalued relative to other options on the same underlying asset.

Conclusion:

Moneyness, intrinsic value, and implied volatility are important concepts to understand when trading options. Moneyness helps traders determine whether an option is in-the-money, at-the-money, or out-of-the-money. Intrinsic value helps traders determine the profit that would be made by exercising the option immediately. Implied volatility helps traders determine the expected volatility of the underlying asset and whether an option is overpriced or underpriced.

By understanding these concepts, traders can make more informed decisions when trading options and can better manage their risk. Apart from these 3 concepts, a trader should also be familiar with the jargon involved in options trading for becoming a good trader.

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