Understanding Moneyness: Options Explained

Moneyness is a basic term describing whether or not you would make money if you exercised your option at the current time. There are three different outcomes for a moneyness measure: in, out or at the money. In the money indicates you would make a profit at this moment, out of the money means you would lose a portion of your initial investment if you exercised the option right now, and at the money means you would break even. The measure is set based on the intrinsic current value of the asset in relation to the current option.

At the Money Example

John purchased a call option for 5 shares of ABC at $10. He invested $5 in the contract option. Right now, ABC is trading at exactly $11 a share. If John where to exercise his call, the would spend $50 buying 5 shares. He could then sell the shares for $55. He would make $5 in the transaction, but this would only leave him at a break even point considering the investment he made in the contract at the time he purchased it. 

In the Money Example

In the above example, John would be in the money if the shares were trading at $12. He would spend $50 to purchase 5 shares, sell the shares for $60, and make $10 in the transaction. This would cover his initial $5 cost and give him an additional $5 in profit. Of course, if he waited until the shares went up to $13 or $14, he would experience an even higher "moneyness" measure. As a result, he may want to wait.

Out of the Money Example

If John does decide to wait, he runs the risk of waiting too long. ABC rises to $13 per share. John thinks it may rise higher, but the next day it crashes back down to $8 per share. If John were to exercise his option, he would spend $50 on the shares, sell them for $40, and lose $10 plus the $5 he spent in buying the contract. The result would be a large loss, and John would not want to make this decision. After reviewing the moneyness of the option at the current point, he may decide to simply leave the option unexercised. At that point, he would only lose the $5 he spent purchasing the contract. 

Determining Moneyness

In the above examples, the sums of money are very small and the trades are very straightforward. In most real-world scenarios, the calculation is far more complicated. However, you can always ask your broker to give you a measure of the moneyness of your contract at any given moment if you are not certain how exactly to calculate the profit yourself. Just remember that the moneyness refers to the current intrinsic value of the asset and option if exercised at this immediately moment. Trades are rarely ever immediately exercised, so the real profits earned could be subject to the timeliness of your trade.