For Option Traders

Find the money

Lesson in Course: Derivatives and options (beginner, 8min)

I have learned that investors can value a promise in a few ways. How does the value of our option change when the value of underlying changes?

Eureka!

What it's about: An actionable way to start thinking about intrinsic and extrinsic value.

Why it's important: Strategies differ for options with different intrinsic values.

Key takeaway: At maturity, out-of-the-money and at-the-money options lose all of their value.

Options have the versatility to be used by investors as a way to take on more risk and potentially amplify gains. Or they can be used to protect the value of an investment from the unknown. Regardless of the strategy, options represent contractual rights with monetary value. Let's review what makes up the intrinsic and extrinsic value of options and learn how to follow the money.

Where's the money today?

As we learned in a previous lesson, the intrinsic value represents the value received today by the owner of the contract if both parties fulfill their obligation of the options. Another way to think about the intrinsic value is the difference between the strike price and the current market price of the underlying. By keeping track of the difference, we can begin to follow the money and understand the three different categories used to describe intrinsic value.

Can we find the intrinsic value?

As a buyer or holder of stock options, we always want our options to be in-the-money at maturity to maximize our chances for profit.

What is In-the-money?

Options are in-the-money when the difference between the strike price and the underlying price benefits the option holder.

A call option is in-the-money for us when we can buy shares at a discount to what's being sold on the market. The stock price has to be higher than the strike price. A put option is the opposite of a call option and is in-the-money when we can sell shares at a premium to the price offered by the market. In this case, the stock price must be lower than the strike price. For this reason, in-the-money options generally have the highest option prices. 

 

At-the-money options offer no discount or premiums and using our options contracts to buy or sell stock results in no difference compared to buying or selling at the market price.

What is At-the-money?

Options are at-the-money when the price of the underlying stock equals the strike price. 

At-the-money can be purchased for a lower price compared to in-the-money options at the same maturity. An important difference is that at-the-money options have no value at maturity. 

At-the-money example

A $9 strike put option for $F is at-the-money when the stock price is $9. At this point, regardless if we use the put option contract or sell $F on the open market, we will receive $9 a share for our Ford stock.

While the price can be an attractive reason to purchase at-the-money options, they are most often used in advanced multi-options strategies such as straddles and strangles. We'll learn more about these in the future. For now, we just need to remember that at-the-money options are in between in-the-money options and out-of-the-money options.

What is Out-of-the-money?

Options are out-of-the-money when the difference between the strike price and the underlying price is bad for the option holder.

Call options are out-of-the-money when the price of the stock is lower than the strike price. Put options are out-of-the money when the stock is higher than the strike price. Out-of-the-money options how the lowest cost and represent the current underdog contracts because they aren't favored to win. Out-of-the-money options also have no value at maturity.

Out-of-the-money example

A quick example of an out-of-the-money call option is a $780 strike price call for $TSLA when the stock is trading at $720. We would never use the contract to buy shares of $TSLA for $780 when we can just buy them on the market for $720.

 

Being able to identify the intrinsic value is a crucial skill. Can we find all three types of intrinsic value in the example of a call and put option on Robinhood today?

Robinhood option chain

Where's the money tomorrow?

Time is one of the factors that cause option prices to change. An in-the-money option purchased today is not guaranteed to stay in-the-money over the next few weeks or months. Our in-the-money position can become further in-the-money or even out-of-the-money if the stock reverses direction. While it's impossible to reliably predict the future, we can observe some larger trends that can help us avoid simple mistakes.

Money flows out of the losers

As the maturity date approaches, out-of-the-money and at-the-money options quickly lose all of their value and the option prices approach $0.

In-the-money options win at maturity

Without any intrinsic value, the option's price is only made up of extrinsic value. As time runs out, this value also goes to $0 because the likelihood of a big change starts diminishing. A simple way to remember this is by revisiting the question above, "How likely is $TSLA to double in price in a few hours compared to a few years?" If we feel like our chances of finishing in-the-money are not good, we shouldn't hold the options to maturity.

Beware! Out-of-the-money trap

The biggest mistake most emerging investors make when using options is to buy cheap out-of-the-money options with short maturity dates.

It's tempting because:

  1. The option prices are among the cheapest
  2. The value of the option can change wildly
  3. The thrill of high stakes gambling

While there is technically nothing wrong with buying out-of-the-money options, not understanding how time impacts these options can result in large losses. As the likelihood to finish in-the-money diminishes, so will the price of the option. While cheap options are very tempting, they are often cheap for a reason. We'll cover how to manage the risk of time or theta decay in future lessons.

 

Actionable ideas

The value in options contracts is largely dependent on changes in the underlying stock price and time. As the contracts get closer to maturity, the extrinsic value decreases until the option price is completely made up of the intrinsic value. Being able to quickly recognize the intrinsic value of our options will help us decide if we want to hold onto an option contract to maturity. This can be the determining factor between a nice payday and walking away empty-handed. If you have a brokerage account that allows you to trade options, can you identify which options are in-the-money as opposed to out-of-the-money?

Glossary

What is In-the-money?

Options are in-the-money when the difference between the strike price and the underlying price benefits the option holder or when the intrinsic value is positive.  For call options, the price of the underlying is greater than the strike price, and for put options, the underlying price is lower than the strike price.

What is At-the-money?

Options are at-the-money when the price of the underlying stock equals the strike price or when the intrinsic value is $0. 

What is Out-of-the-money?

Options are out-of-the-money when the difference between the strike price and the underlying price benefits the option seller or when the intrinsic value is negative. For call options, the price of the underlying is lower than the strike price, and for put options, the underlying price is greater than the strike price.