8.1 – Intrinsic Value

With our previous discussions on the intrinsic value of an option, the concept of moneyness should be fairly simple to grasp. The moneyness of an option is a classification method that ranks each option strike according to how much money a trader will make if he exercises his option contract today. There are three broad categories –

1. In the Money (ITM)
2. At the Money (ATM)
3. Out of the Money (OTM)

And for all practical purposes, I guess it is best to further classify these as –

1. Deep In the money
2. In the Money (ITM)
3. At the Money (ATM)
4. Out of the Money (OTM)
5. Deep Out of the Money

The concept of moneyness should be fairly simple to grasp given our previous discussions on the intrinsic value of an option. An option’s moneyness is a classification method that ranks each option strike based on how much money a trader will make if he exercises his option contract today. There are three major categories:

Let us use an example to better understand this. As of today (7th May 2015), the Nifty is trading at 8060. With this in mind, I’ve taken a snapshot of all the available strike prices (the same is highlighted within a blue box). The goal is to categorise each of these strikes as ITM, ATM, or OTM. We’ll talk about the ‘Deep ITM’ and ‘Deep OTM’ later.

The available strike prices trade start at 7100 and go all the way up to 8700, as shown in the image above.

We’ll start with ‘At the Money Option (ATM)’ because it’s the simplest to deal with.

According to the ATM option definition that we posted earlier, an ATM option is the option strike that is closest to the spot price. Given that the spot is at 8060, the closest strike is most likely at 8050. If there was an 8060 strike, 8060 would undoubtedly be the ATM option. However, in the absence of 8060 strikes, the nearest strike becomes ATM. As a result, we classify 8050 as an ATM option.

After we’ve determined the ATM option (8050), we’ll look for ITM and OTM options.

1. 7100
2. 7500
3. 8050
4. 8100
5. 8300

Do remember the spot price is 8060, keeping this in perspective the intrinsic value for the strikes above would be –

@ 7100

Intrinsic Value = 8060 – 7100

= 960

Non zero value, hence the strike should be In the Money (ITM) option

@7500

Intrinsic Value = 8060 – 7500

= 560

Non zero value, hence the strike should be In the Money (ITM) option

@8050

We know this is the ATM option as 8050 strike is closest to the spot price of 8060. So we will not bother to calculate its intrinsic value.

@ 8100

Intrinsic Value = 8060 – 8100

= – 40

Negative intrinsic value, therefore the intrinsic value is 0. Since the intrinsic value is 0, the strike is Out of the Money (OTM).

@ 8300

Intrinsic Value = 8060 – 8300

= – 240

Because there is a negative intrinsic value, the intrinsic value is 0. Because the intrinsic value is zero, the strike is ineligible (OTM).

You may have picked up on the generalisations (for call options) that exist here, but allow me to reiterate.

OTM are all option strikes that are higher than the ATM strike.

All option strikes that are less than the ATM strike are regarded as ITM.
In fact, I recommend that you take another look at the snapshot we just posted -7100.

NSE displays ITM options on a pale yellow background, while all OTM options have a standard white background. Let’s take a look at two ITM options: 7500 and 8000. The intrinsic values are 560 and 60, respectively (considering the spot is at 8060). The greater the intrinsic value, the more profitable the option. As a result, 7500 strikes are considered “Deep in the Money,” while 8000 strikes are considered “In the Money.”

I would advise you to keep track of the premiums for all of these strike prices (highlighted in the green box). Is there a pattern here? As you move from the ‘Deep ITM’ option to the ‘Deep OTM option,’ the premium decreases. In other words, ITM options are always more expensive than OTM options.