ATM, ITM and OTM options: what moneyness means

The definitions for calls and puts

A call gives the right to buy at the strike, so it is in the money when the stock is above the strike. With a stock at 105, a 100 call is 5 dollars in the money: exercising it would buy stock at 100 that is worth 105. A 110 call is out of the money, because buying at 110 a stock worth 105 has no value.

A put gives the right to sell at the strike, so it is in the money when the stock is below the strike. With the stock at 105, a 110 put is 5 dollars in the money and a 100 put is out of the money.

At the money refers to the strike closest to the current price. With the stock at 105, the 105 call and the 105 put are both at the money. Traders also use near the money for strikes within a short distance either side.

Intrinsic and extrinsic value

An option's price splits into two parts. Intrinsic value is the amount it is in the money: 5 dollars for the 100 call with the stock at 105. Extrinsic value, also called time value, is everything above that: the price of the possibility that the option becomes worth more before it expires.

Out-of-the-money options have no intrinsic value; their entire price is extrinsic. At-the-money options also have little or no intrinsic value, but they carry the most extrinsic value of any strike, because uncertainty about where they finish is greatest. Deep in-the-money options are mostly intrinsic value, with a small amount of time value on top.

At expiration, extrinsic value goes to zero. An option is then worth exactly its intrinsic value, which is zero for anything out of the money.

How each one behaves

In-the-money options have high deltas and behave much like the stock. A deep in-the-money call with a delta of 0.90 moves about 90 cents for each dollar the stock moves. They cost more, have less leverage, and lose less to time decay in percentage terms.

At-the-money options have deltas near 0.50, the highest gamma, the highest dollar theta and the highest vega. They are the most sensitive to movement, time and volatility, which makes them the main tool for trading volatility and the most actively hedged by dealers.

Out-of-the-money options have low deltas, are cheap, and need a move to pay off. They offer the most leverage and the highest chance of expiring worthless. Their percentage changes can be very large in both directions.

Moneyness and dealer hedging

Moneyness also determines where dealer hedging is most active. At-the-money options carry the most gamma, so dealer hedges against them change the most for each move. As price moves toward a strike with heavy open interest, those options move toward the money, their gamma rises, and the hedging attached to them becomes more active.

That is the reason levels on a gamma map matter more as price approaches them. A heavy strike far out of the money carries little gamma and little hedging pressure. The same strike, once price is close to it, can carry the most gamma on the board, because the same open interest is now at the money.

Moneyness by delta

Because a five-dollar distance means something very different on a 50-dollar stock than on a 500-dollar index, professionals often describe moneyness by delta instead of by dollars. A 25-delta put is a put whose delta is minus 0.25, wherever that strike happens to be. That standardises comparisons across underlyings, expiries and volatility levels.

It also explains why the same strike can drift from out of the money to near the money without the stock moving. As expiry approaches, or as implied volatility falls, out-of-the-money deltas shrink and the strike becomes effectively further away.

Some traders use the ratio of strike to price, or the distance in standard deviations implied by volatility, instead. All of these are ways of saying the same thing more precisely than in the money or out of the money: how far the strike is from price relative to how far price is likely to travel.