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Option Moneyness Explained
Option premium value comprise of two values. Intrinsic value and extrinsic value (Time value).
1. Intrinsic value: Intrinsic Value is the value of stock taking into consideration of all the fundamental factors that currently exist for the stock. Its value can be different than actual market price. Its also called as fair value or fundamental value.
Intrinsic value of the option is the current profit from the option. If underlier's price remains as it till expiry date then this will be realized profit.
For call option it is (Current market price Minus strike price)
For put option it is (Strike price Minus market price).
Intrinsic value has a meaning only in case of 'In the money stock' for other case its value is always zero.
Intrinsic value however changes with time and with implied volatility.
2. Time value: It is that part of premium which is paid to keep option valid for certain duration. The greater the period the higher the time value as it gets option buyer to bet for longer duration. By definition it is the difference between premium and Intrinsic value.
Time value of the option decrease with passage of time and is 0 during option expiry. This is also called as time decay
Type of Moneyness
1. In the Money (ITM): It is the state where option is making some money or when intrinsic value exist (value greater than zero).
For call option it is 'In the money' when market price is greater than Strike price.
For put option it is 'In the Money' strike price is higher than market price.
Scenario 3 is example of ITM.
2. At the Money (ATM): It is a state when the strike price is equal to market price. No profits are generated for the buyer. It is good state from sellers point of view as they earn premium.
Scenario 2 is example of ATM.
3. Out of Money (OTM): This is the state when option exercise will give loss to the buyer. In such cases options are not exercised.
Scenario 1 is example of OTM
As you see in this example that option is zero sum game. You gain at the cost of somebodies loss.
Various scenarios after one month
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