Options have a characteristic called Moneyness;

• This is usually understood to mean an option at a particular strike price is either in the money, ITM or out of the money OTM.

ITM

This condition of being in-the-money or ITM means the strike price is below the current market price, on the day the option was purchased.

OTM

If an option strike price is above the current market price on the day the option was purchases, it is referred to as being out-of-the-money or OTM.

Intrinsic and Extrinsic Value

• Another concept or characteristic of options is that the value of an option is composed of two parts, the intrinsic portion and extrinsic portion. Understanding this is also an important part of understanding moneyness.

Intrinsic Value

• This the portion of the options value or price, which is attributed to the difference between the strike price of the option, and the current underlying asset's price. But this value only exists when the oprion strike price is below the underlying asset's current market price.
• An explanatory Example: If the market value of stock X is 100 dollars, and the strike price of the option you choose is 95 dollars, the intrisic value of that option is 100 minus 95, or 5 dollars.

Extrinsic Value

• Extrinsic value refers to value of time, between the date the option is purchase and the date of the expirations.
• To calculate extrinsic value we take the price of the option, and subtract the intricsic value of the option, and that is the extrinsic value.
• This is deductive reasoning because we know the value of the option is the sum of the intrinsic value and the extrinsic value.
• So we know that we can calculate the extrinsic value by subtracting the intrinsic value from the total value.
• An explanatory example would be if your option is 4 dollars, and it's intrinsic value is 2 dollars, then the extrinsic value must be 4 dollars minus 2 dollars or 2 dollars.
• If the value of the option was 5 dollars, and the intrinsic value of the option was 2 dollars, then the extrinsic value must be 5 dollars minus 2 dollars, or 3 dollars.

Other characteristics and things to know

• At this point having given you a few examples of how to calcultae value, I should point out that options with intrinsic value are by definition below the current market price, and their intrinsic value tends to be greater then their extrinsic value. So if an option price is 4 dollars, it's value is 4 dollars, and it's intrinsic value is probably 3 of those four dollars.
• Options which are out of the money or OTM have no intrinsic value by definition and their value is only extrinsic value.
• Extrinsic value is by definition the value of the number of days between today and the expiration day, which is called Time, so Extrinisc Value is sometimes called Time Value not Extrinisc Value.
• Time Value is an important characteristic of options, so it's important to understand synonyms like this.

Summary

• Option moneyness refers to whether an option is in-the-money ITM, or out-of-the-money OTM. All options have value, which is the sum of the options extrinsic and intrinsic value.
• All options have Extrinsic value, which is the value of the time left between todays date and the expiration date.
• But not all options have intrinsic value, which is the difference in price betwen the option strike price and the current market value.
• Only in-the-money options, which have a strike price below the current market price of the underlying have intrinsic value.
• Understanding Moneyness is key to understanding other important characteristics of options, like the options greeks.
• Any questions?

Introduction to Options Part Five: Moneyness.