When navigating the complex world of options trading, it's essential to understand the terminology that governs market movements and pricing. One such term is "near the money," which plays a significant role in determining an options contract's profitability and risk.
What Does "Near the Money" Mean?
The phrase "near the money" refers to an options contract whose strike price is close to the current market price of the underlying security. It indicates a state of the options contract that is not quite "at the money" (ATM) but is often used interchangeably with it due to the infrequency of a strike price aligning perfectly with the market price.
Key Concepts:
- Call Options: A call option is considered "in the money" (ITM) if its strike price is lower than the current market price of the underlying asset. Conversely, if the strike price exceeds the market price, it is termed "out of the money" (OTM).
- Put Options: The moneyness of a put option is evaluated in the opposite direction; it is ITM if the strike price is above the market price and OTM if it is below.
- Premiums and Moneyness: The intrinsic and extrinsic values attached to an options contract are critical for understanding their moneyness. While "near the money" is a state of moneyness, it remains essential to consider the contract's premium since this influences its overall value.
How Is "Near the Money" Determined?
An options contract is categorized as "near the money" when the difference between the strike price and the market price of the underlying asset is relatively small—typically defined as less than 50 cents. For example, if the current market price of a stock is $20 and the strike price of an associated call option is $19.80, it is considered near the money because the difference is merely 20 cents.
Contrastingly, a contract is "at the money" when the strike price precisely matches the market price of the underlying security. Given the rarity of this occurrence in options trading, many transactions occur with near-the-money options, making the term widely applicable in the market.
The Value of Near-the-Money Options
Near-the-money options usually have higher premiums compared to out-of-the-money options, which have strike prices that differ significantly from the underlying asset's price. This is because near-the-money options contain intrinsic value.
- Intrinsic Value: This refers to the inherent value of the option, which is influenced by how close the strike price is to market price.
- Extrinsic Value: This encompasses additional factors—time until expiration and market volatility—that give the option its additional value beyond intrinsic worth.
Options that are slightly in the money can exhibit both intrinsic and extrinsic value, enhancing their attractiveness for traders looking to capitalize on market fluctuations.
Near the Money vs. At the Money
As it is rare for options to line up exactly with the underlying asset's strike price, most trades will revolve around near-the-money options. Traders generally prefer ITM options to potentially profit from a trade by purchasing them at a lower price than the current market price.
When options are at the money, they are often assigned a delta value of approximately 0.5 for call options and -0.5 for put options. The delta value indicates the sensitivity of the option's price to changes in the underlying asset's price, suggesting an equal probability of ending in or out of the money by expiration. However, near-the-money options will reflect a delta value that varies depending on their proximity to the strike price.
Conclusion
Understanding "near the money" is crucial for any options trader, as it affects both the pricing dynamics and the potential profitability of options contracts. This classification, as part of the broader concept of moneyness, gives traders insight into market behavior and informs strategic decisions. As the options market continues to grow, grasping these terms will help investors and traders navigate their options strategies more effectively.