When it comes to trading in option derivatives, one might have noticed that there is a lot of use of the word "moneyness", understanding the concept of moneyness is crucial. Moneyness is a term used to describe the relationship between the current price of the underlying asset and the strike price of an option.
In the options market, the term "moneyness" describes whether an option derivative is either "in-the-money" (ITM), "out-of-the-money" (OTM), or "at-the-money" (ATM).
in-the-money options: A call option is said to be "in-the-money" when the price of the underlying asset is trading above the option's strike price. A put option is said to be "in-the-money" when the price of the underlying asset is trading below the option's strike price.
out-of-the-money options: A call option is said to be "out-of-the-money" when the price of the underlying asset is trading below the option's strike price. A put option is said to be "out-of-the-money" when the price of the underlying asset is trading above the option's strike price.
at-the-money options: A call and a put option are said to be "at-the-money" when the price of the underlying asset is trading equal to their option's strike price.
Moneyness Impacting the Intrinsic Value of an Option
The price of an option is the sum of components; intrinsic value and extrinsic value.
Option Price = Intrinsic Value + Extrinsic Value
A long call option is meant to provide exposure on the upside i.e. the price of the underlying asset greater than the call option's strike price, also called the "in-the-money" option. It means that this call option will have some intrinsic value as the buyer of the "in-the-money" call option is accounting for some positive exposure, and upon exercise, the buyer will at least gain an amount equal to the difference between the strike price and the price of the underlying asset.
"a long call option gives a right, not an obligation."
In case the price of the underlying asset is trading equal to i.e. "at-the-money" or below the call option's strike price i.e. "out-of-the-money", the buyer of a call option will not be exercising this option, and hence, this option will expire worthlessly. Therefore, "at-the-money" and "out-of-the-money" options will have no intrinsic value.
for a call option,
Intrinsic Value = Max(Underlying Price - Strike Price, 0)
for a put option,
Intrinsic Value = Max(Option's Strike Price - Underlying Price, 0)