Options are classified as “in-the-money,” “at-the-money” or “out-of-the-money.” Each of these phrases has a distinct meaning and each option strike price will fall into one of the three categories. But how do you know which is which?
If you keep in mind the rights that options convey to the buyer, then the differences between the three types of moneyness will be easier to understand. Let’s quickly review the rights.
Buying a put gives you the right to sell the stock for the strike price any time before expiration.
A call gives you the right to buy the stock for the strike price any time before expiration.
Options Chain Sheet
There is typically only one strike price that is considered “at-the-money.” That strike price is the one closest to the current stock price. In the chain sheet above for Priceline (PCLN), the at-the-money strike price is 880. That is because the current price of the stock is $881.98 per share. There is no other strike price closer to current price of the stock.
The in-the-money strike prices are those with “intrinsic value.” Intrinsic value means that the right conveyed by the option is worth something. For example, if you owned the 800 strike call above, you have the right to buy the stock for $800 a share. Because the current price of the stock is $881.98 the option has intrinsic value of $81.98 per share. Similarly the 885 put strike price has intrinsic value of $3.02 per share because that strike price is $3.02 above the current stock price.
In this example it doesn’t apply, but if the in-the-money option costs more than its intrinsic value, the difference between the option’s price of per share and its intrinsic value is called time value or “premium.”
An option with a strike price that is out-of-the-money is an option that has no intrinsic value. For example, since the call with a strike price of 885 gives you the right to buy PCLN for $885 before expiration, that right has no value. That is because the stock is currently worth $881.98, therefore, you could buy the stock on the open market for cheaper.
Sometimes these options still have some value because the stock could rise before expiration and it would then acquire intrinsic value. In this example the value of the 885 calls is 14 cents per share, which is all time value or premium.
How to Keep it All Straight
- Puts with a strike price above the current stock price and calls with a strike price below the current stock price are “in-the-money.” The further the strike price is in-the-money, the more expensive that option will be because it has more intrinsic value.
- Puts with a strike price below the current stock price and calls with a strike price above the current stock price are “out-of-the-money.” The further the strike price is out-of-the-money the less valuable it becomes because it is less likely that the option will ever acquire intrinsic value.
- At-the-money options may be a little in or out-of-the-money. They will, however, always be the strike price that is closest to the current stock price.
The bottom line is that an options price will rise and fall with the stock but you are not restricted based on how close the strike price is to the stock’s price for when you can close the option and take profits. If you buy an option today for $1.00 and its worth $1.50 per share on Friday, you can sell it for a 50-cent gain regardless of whether the option’s strike price is equal to the stock’s price or not.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.