Every day, people hear terms such as "money in," "money out" and "being in the money." These are pretty easy for many people to understand but there is one thing you may not have known before now: what does it really mean when something is "in the money?" That's where this lengthy guide comes in. While you won't find any hard-to-understand formulas, this article will fill you in on the definitions of all the most common terms you'll hear pertaining to options and stock trading.
What is in The Money?
An option that is "in the money" means it has intrinsic value. This means it can be exercised at any point before expiration for a profit because there is a profit on the trade even if you close your position at any point before expiration.
When we say that something is "in the money" -- or "of value" -- we simply mean that it's worth more than its price. A call option, for example, is said to be "in the money" if it is "out of the money" by a certain amount. If you have a call option with an exercise price of $10 and the market currently trades at $14, then your call option is said to be in the money by $4 ($14 - $10 = $4). A put option that has a strike price of $10 and it's trading at $8 is also in the money by the same amount.
Another way to think of it is by looking at the option's intrinsic value. If you look at a call option's intrinsic value, then $4 would be its intrinsic value. If the strike price and the current stock price are equal, then it has no inherent value or intrinsic value. That is known as being "at-the-money." The strike price, on the other hand, may have some amount of time value due to volatility as well as interest rate concerns (we'll discuss this later).
What is Out of the Money?
In the opposite situation, something is said to be "out of the money" or "of no value." This simply means that something is worth less than its price. An option that is "out of the money" means it has no intrinsic value. This means it cannot be exercised and a profit is only achieved if you close your position at expiration.
If you have a call option but it's trading at $15, then your call option is said to be "out of the money" by $5 ($15 - $10 = $5). If you have a call option but it's trading at $6, then your call option is "out of the money" by $3 ($15 - $6 = -$3). If you have a put option but it's trading at $8, then your put option is said to be "out of the money" by $1 ($10 - $8 = -$1).
What is Being in the Money?
Being "in the money" means having a positive amount of intrinsic value. If you have a call option but it's trading at $14, then your call option has a value of $1 ($14 - $10 = $1). If you have a put that is "in the money" by $2, then it has an intrinsic value of $2. If you have a call option that is "out of the money" by $4, then your call option has an intrinsic value of -$4 ($12 - $10 = -$4).
What is Being at the Money?
Being "at the money" means that you have a zero intrinsic value. If you have a put option but it's trading at $10, then your put option has zero intrinsic value. In fact, it would be said to be "at-the-money." Just as in being out of the money, some amount of time value may remain. If you have a call option but it's trading at $5, then your call option shows a negative value of $2 ($15 - $10 = -$2). If you have a call option that it's trading at $8, then your call value is zero ($15 + $8 = $15).
What is the Time Value of an Option?
You may wonder what we mean by "time value." Time Value is the amount an option's price exceeds its intrinsic value. If you have a call option but it's trading at $8, then it may be said to have some time value remaining. In this case, that $2 would be considered "time value." If you have a put option but it's trading at $3, then it also has some time value of $1 ($4 - $3 = $1). In this case, $1 is considered "time value."
Why does time value exist?
This is often explained with a story about a gambler who played blackjack against an expert. The gambler has a hand worth 17 and the dealer has a blackjack. Since the card is in his favor, he wants to win the hand. When he's dealt his cards, he's happy to see that he gets two cards of 21 -- which are better than even money. In effect, he has a hand worth 21 but he's only dealt 17. What the gambler doesn't know is that even though his hand is an improvement to what's already there, it isn't significant enough to win the game. The gambler loses because of time value and the odds are against him.
A similar situation applies in options trading, which can explain why time value exists. For instance, you may have a call option and your stock is trading at $40. However, you had bought that call when the stock was trading at $50 and the dividend yield was higher than today. In essence, you're still earning your dividend but it has declined in value by 18 percent (1 - (.18 * 50)). You've also lost the effect of capital appreciation because of a decline in price -- but that's usually considered to be less significant.
