Updated: Apr 8, 2021
Welcome back with a new article regarding options trading. In the previous article, we had discussed the strategy of how to find an option contract. What is the correct form of choosing the right contract? In this brand-new article on option trading, we are going to learn about the moneyness of the options contracts.
A well-liked term concern to options is the moneyness of the options contracts. The moneyness of an option is fundamentally a determinant of whether the specific option has a positive intrinsic value or an intrinsic value of zero. Remember this, the intrinsic value of an option contract can never be negative; the lowest feasible intrinsic value of an option is zero. The intrinsic value of the option is the difference between the spot price and the strike price.
The reason the moneyness of an option contract is the key highlight is that it finds whether the option contract is valuable or not. To understand moneyness we first need to understand the idea of the intrinsic value of an option. Let us find out the moneyness of a call option contract in this case and the larger idea of moneyness in options.
Options can be categorized into three categories that are also mentioned as moneyness of the options contracts. Options Moneyness is used as a mark to decide if the option contract will make money if it were right away exercised.
The categories of moneyness of options contracts are At the Money (ATM) option, Out of the Money (OTM) option, and In the Money (ITM) option. This classification helps the trader in the major role which strikes price to trade, given a specific situation in the market.
Assuming you bought the Reliance share at 2000 CE strike price and the spot price of the Reliance is at Rs. 2100 and instead of waiting for 20 days to expiry day, you had the right to exercise the option contract today. Now my question to you is – How much money would you be going to make provided you exercised the option contract today?
Do you know when you exercise a long option, the money you generate is equivalent to the intrinsic value of an option contract minus the premium reward? Hence, to answer the above question, we need to calculate the intrinsic value of an option contract, for which we need to use the call option intrinsic value formula.
As we know the formula of the intrinsic value of call option –
IV of call option = Spot price – Strike price
Let us put the values into the equation
So, if you were to exercise this option contract today, you are entitled to make 100 points (Let's ignore the premium paid).
So, mastering these options, strike classification is very easy. All you need to do is find out the intrinsic value of the option contract. If the intrinsic value is greater than zero, then the option strike is called as ‘In the money’ option contract. If the intrinsic value is a zero number, then option strike is called as ‘Out of the money’ option. And if the strike price, which is nearest to the spot price, is called as ‘At the money’ option.
So, you must have understood about the moneyness of the options. But a question arises “Why is the moneyness of options contracts so important”? Typically, options can either be exercised or they can be sold in the market to square off your existing positions.
The concept of moneyness is very important for calls because the option will be exercised only in the case of ITM options contracts, not for ATM and OTM options contracts. There is an interesting point to look upon here. Moneyness has nothing to do with the premium of the options contracts and is only bothered with the relationship between spot price or market price and the strike price.
If you have bought a 2000-call option on Reliance at Rs. 80 and the stock price is now Rs. 2100, you will end up with a net loss of Rs. 20. But in terms of the moneyness of the options contracts, these call options are still an ITM option because the moneyness of the option is helping you to lower your losses. That is all about the moneyness of a call option. And you will reverse all the procedures, it will become the moneyness of the put option.
Now, what is POP? The probability of profit (POP) is the probability assigned by the options market of the stock closing at the equal point of a trade. Beyond or inside that breakeven or equalize will find out whether the trade is profitable or a losing trade at the expiry day.
The Credit spreads will frequently have a POP greater than 50% at entry, with most of the debit spreads the POP will be less than 50%. When entering into the position, a trader can use the probability of profit to compare possible trades. Once in an options position, the current probability of profit (as well as the probability of the maximum loss or the maximum gain) can help with trade management, entry, and exits of the positions as well.
An option premium is a price that is paid by the trader for a call and put options contract. When you buy an option, you’re obtaining the right to trade its underlying market price at a specified price for a set period. The actual amount you pay for this right is called the option premium.
The size of an option’s premium is affected by the three main factors: the price of the underlying asset, its level of volatility or the risk, and the option’s time to expiration. As long as the time increases, the premium of the option will decrease. Because the option premium depends upon the intrinsic value as well as the time value. As the expiry date came, time decay will happen and option premium will decay. So, I would suggest you not buying the deep out-of-the-money options as their premium will not increase as the proportion of the market increases. You can sell the deep out of the money to get the maximum profit with the least amount of risk.
Suppose you have Rs. 1,00,000 and you want to get a return of let’s say 3%. So, choose that type of strike price which is deep in the money and yes, their premium will be much lower as per the requirements but you can get a good profit by selling the option contacts. If you want to buy an option, choose that strike price which is near the ATM option.
So, in conclusion, I would like to say that before doing the options trading, learn about the teams and basics of options trading strategies.