Moneyness describes where the underlying price sits relative to an option's strike. It decides how much of the option's price is real, exercisable value and how much is hope: what traders call intrinsic value and time value.
| Call (strike 100) | Put (strike 100) | Intrinsic value | |
|---|---|---|---|
| In the money (ITM) | Stock above 100 | Stock below 100 | Yes |
| At the money (ATM) | Stock near 100 | Stock near 100 | About zero |
| Out of the money (OTM) | Stock below 100 | Stock above 100 | None |
What makes up the premium
Premium = intrinsic value + extrinsic (time) value. Intrinsic value is what the option would be worth if exercised right now. Time value is everything else: the chance the option becomes more valuable before expiry.
What drives time value
- Time to expiry: more time means more chance of a big move, so more time value.
- Volatility: the more the underlying is expected to move, the more an option is worth (chapter 4).
- Distance from the strike: time value is highest at the money and shrinks deep in or far out of the money.
- Interest rates and dividends also play a smaller part.
Worked example
A stock is at $105. A 100-strike call costs $7.20.
Intrinsic value = $105 − $100 = $5.00. Time value = $7.20 − $5.00 = $2.20.
If the stock is still at $105 at expiry, the call is worth only $5: the $2.20 of time value has gone.
Key takeaways
- In the money options have intrinsic value; at and out of the money options are mostly or entirely time value.
- Premium = intrinsic value + time (extrinsic) value.
- Time value is highest at the money and falls to zero at expiry.
- Time to expiry and volatility are the biggest drivers of time value.