Moneyness in Options contract

Moneyness is a term to describe whether a contract is either ‘in the money’, ‘out of the money’, or ‘at the money’. This classification helps the trader to decide which strike to trade, given a particular circumstance in the market. To get a clear picture of this we need to understand the concept of intrinsic value of an option.

The intrinsic value of an option is the money the option buyer makes from an options contract provided he has the right to exercise that option on the given day. Intrinsic value is always a positive value and can never go below zero.

Let us take an example.

Nifty is approximately trading at 18500 currently.

Spot price: 18500

Option strike: 18450

Option type: CE

Expiry date June 1st

Position: Long

A call option is said to be ‘in the money’ when the future contract price is above the strike price. A call option is ‘out of the money’ when the future contract price is below the strike price.

Assuming I bought this option on Monday, and I sell it on the same day without waiting for expiry what is the amount I would make?

Intrinsic value of a call option = spot price - strike price

Spot - strike

18500-18450 = 50

So, if you were to exercise this option today, you are entitled to make 50 points (ignoring the premium paid).

The following is a table which calculates the intrinsic value for various options strike (these are just random values to understand the concept)

Now it's clear about the intrinsic value calculation for a given option strike. Key points to be noted are.

• The intrinsic value of an option is the amount of money you would make if you were to exercise the option contract.

• The intrinsic value of an options contract can never be negative. It can be either zero or a positive number.

• Call option intrinsic value = spot price – strike price

• Put option Intrinsic value = strike price – spot price

Now why the intrinsic value cannot be negative?

To answer this, let us pick an example from the above table – strike is 250, the spot is 245, and option type is a long call. Let us assume the premium for the 250 call option is Rs 15. Now,

• If you were to exercise this option, we would get the intrinsic value.

• How much is the intrinsic value?

Intrinsic value = 245-250 = -5

• The formula suggests we get ‘- Rs 5’. This means Rs 5 is going from our pocket.

• Let us believe this is true for a moment; what will be the total loss? 15 + 5 = Rs 20

• But we know the maximum loss for a call option buyer is limited to the extent of the premium one pays; in this case, it will be Rs 15

However, if we include a negative intrinsic value, this property of option payoff is not obeyed (Rs 20 loss as opposed to Rs15). However, to maintain the non-linear property of option payoff, the intrinsic value can never be negative. To conclude the intrinsic value of an option can never go negative.

(The author is a homemaker, who dabbles in stock market investments in free time)