Moneyness

Moneyness answers one question about an option, today: if I exercised it this instant, would I be better off?

• In the money (ITM) — exercising produces a positive cash flow. A call is ITM when the strike is below the underlying price; a put is ITM when the strike is above it.
• At the money (ATM) — the strike equals the spot exactly. Exercise produces nothing. Any move from here pushes it one way or the other.
• Out of the money (OTM) — exercising would produce a negative cash flow, so nobody does it. A call is OTM when the strike is above spot; a put is OTM when the strike is below.

Note what the classification ignores: the premium you paid. An option can be comfortably in the money and still have lost you money. Moneyness is about the exercise decision, not the profit and loss.

Moneyness is the same thing as intrinsic value, expressed as a label instead of a number.

Intrinsic value of a call = max(Spot − Strike, 0)
Intrinsic value of a put  = max(Strike − Spot, 0)

Intrinsic value can never be negative, because nobody exercises into a loss. So only ITM options have intrinsic value; ATM and OTM options are made of time value and nothing else.

Exchange traded USDINR options are listed at strike intervals of Rs 0.25 — 82.75, 83.00, 83.25, 83.50 and so on — and the exchange keeps at least 12 in-the-money, 12 out-of-the-money and one near-the-money strike available on every contract. "Near the money" exists as a category precisely because a listed strike rarely sits exactly on the spot rate, so a strictly at-the-money option is a textbook case more than a traded one.

Premium = Intrinsic value + Time value
At expiry: Time value = 0, so Premium = Intrinsic value

USDINR is trading at 83.15. The listed strikes around it are 82.75, 83.00, 83.25 and 83.50. Each contract is USD 1,000.

No strike is at the money — 83.15 is not a listed strike. The near-the-money strike is 83.25, being 0.10 away rather than 0.15.

In rupees, per contract of USD 1,000:

83.00 call, intrinsic value = 0.15 × 1,000 = Rs 150
83.25 put,  intrinsic value = 0.10 × 1,000 = Rs 100
83.25 call, intrinsic value = 0.00 × 1,000 = Rs   0

Now suppose the 83.00 call is quoted at 0.28. Then:

Intrinsic value = 0.15   → Rs 150
Time value      = 0.13   → Rs 130
Premium         = 0.28   → Rs 280 per contract

And here is the trap in rupees. A trader who bought that 83.00 call at 0.28 is holding an option that is in the money and is nonetheless down Rs 130 a contract. On 20 contracts that is Rs 2,600 of loss on a position the screen is colouring green. His breakeven is 83.00 + 0.28 = 83.28, and the spot is 83.15.

At expiry, if the FBIL reference rate settles at 83.15, the call is cash settled for its intrinsic value of Rs 150 a contract — Rs 3,000 on 20 contracts against Rs 5,600 of premium paid.

Chapter 4 (Exchange Traded Currency Options), section 4.4, is devoted to moneyness and carries the strike-versus-spot table; section 4.5.1 splits the premium into intrinsic and time value. Between them they generate more questions than almost anything else in the paper.

The standard forms are: given a spot and a strike, classify the call and the put; state which moneyness categories have zero intrinsic value (ATM and OTM); and compute the intrinsic and time components of a quoted premium. Chapter 4 also uses moneyness to set up delta, and Chapter 5 uses it to choose strikes for spreads.

• Moneyness ignores the premium. ITM does not mean profitable. Profit needs spot beyond strike + premium for a call, or below strike − premium for a put.
• The call and put at one strike are always opposites. If the 83.25 call is OTM, the 83.25 put at the same moment is ITM. They can never both be in the money.
• ATM and OTM options have zero intrinsic value, not zero premium. They still trade, because they carry time value, and that time value is what a spread trader is buying and selling.
• Intrinsic value is floored at zero — never negative. An option "in the money by minus 0.20" is simply out of the money.
• A listed strike rarely equals spot, so "near the money" is the practical category and ATM is the theoretical one. The contract specification guarantees one near-the-money strike, not an ATM one.
• Exchange traded currency options are European and premium style: moneyness during the life tells you what the option is worth, but exercise only happens at expiry, against the FBIL reference rate.