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Article / 19 April 2018 at 9:05 GMT

"Moneyness" – options to give investors choice

Director, Europe / The Options Industry Council (OIC)
United Kingdom
By Gary Delany

Today’s web post covers something more generic which can sometimes get lost in the detail. The theme is quite simple – ‘moneyness’. Moneyness refers to the relationship between the option strike price and the price of the underlying asset. ‘Moneyness’ for a bought call option looks like this:

chart
Source: The author 

By varying the strike prices selected in strategies you can fine tune cost and cover. This is true for the most simple strategies (buy a call or buy a put), as well as the more advanced ones, such as spreads and collars. This observation reflects one of the basic characteristics of an option, the fact that an option’s profile is asymmetrical. When an investor is holding a stock or a future, her profile is linear. If the underlying stock or ETF moves, the investor will make money if the price rises above the purchase price, or lose money if it falls below the purchase price. For an option, the profile is asymmetrical – the typical "hockey stick" graph, with the bend in the "stick" being dictated by the strike price.

chart
 Source: The author

Options have more variables than stock. For a stock, the variables are the price and any corporate action (e.g. dividends, stock splits). For an option, the variables include the relationship between the strike price and the underlying price ("moneyness"), the expiration date, and whether the option is bought or sold.

By selecting options with varying degrees of "moneyness", the options used in any strategy can be made more or less expensive. Other influences being equal, out-of-the-money options are cheaper than at-the-money. In-the-money options will be more expensive. There is of course a trade-off: an out-of-the-money option delivers a less advantageous (i.e. higher) price in the case of a bought call option, or a lower price in the case of a bought put option.

Straddles and strangles

Let’s look at some examples of where different option positions are employed to create a strategy. A long straddle uses a long call and a long put of the same expiration and strike price. Below is an example of a long 50 strike straddle.

chart
Source: The author 

A long strangle is similar. It involves buying a put and a call option of the same expiration, but with out-of-the-money strike prices, which reduces the cost of the position. The call option bought has a higher strike price and the put option bought has a lower strike price. Below is an example of a 45/55 strangle. 

chart
Source: The author  

In short, straddles involve a higher cost and lower leverage. The break-even points of the strategy are closer together, and there is a lower chance of a total loss. The strangle is the converse: lower cost and higher leverage, with the break-even points further apart and a greater chance of a total loss. For both strategies, time decay is painful and because both strategies involve purchasing two options, a large move in the underlying stock price is needed to make the position profitable. Because the strike prices in the strangle are further apart than for the straddle, the strangle requires a larger move in the underlying to make money. Both strategies anticipate implied volatility to increase.

Collars

The Protective Collar is another strategy where the options employed can be less, or more, out-of-the-money, which will have an impact on cost and cover. The collar allow investors to protect their underlying asset.

A collar is constructed around a stock or ETF holding. An out-of-the-money call is sold at a strike price above the current market price. At the same time an out-of-the-money put is bought at a strike price below the current market price. The revenue from the call sold will partly or wholly offset the cost of the put bought. The call sold places a limit on the upside potential of the stock owned, while the put bought establishes a minimum price on the downside. Below is an example of a 52.50/60 collar.

chart
 Source: The author

The strike price of the call sold can be moved up, further out-of-the-money (cheaper, other factors being unchanged), or down and less out-of-the-money (more expensive). Likewise, the strike price of the put bought can be moved up, less out-of-the-money (more expensive), or moved down, further out-of-the-money (cheaper). By selecting differing degrees of moneyness, the coverage gained can be more – or less – extensive.

Conclusion
The variables that options offer (put or call; buy or sell; time to expiration and moneyness) allow investors great scope to construct the strategy that suits them. In this article we have focused on how by adjusting the relationship between the strike price and the underlying price (‘moneyness’), the investor can adjust the cost of the strategy and the coverage gained.
If you found this web post beneficial, consider reading my other fifteen posts published on Saxo's TradingFloor.com that cover topics from strategies to market segments to industry structure.

Gary Delany is European director of the Options Industry Council.

Disclaimer:
Options involve risk and are not suitable for all investors. Individuals should not enter into Options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, which may be obtained from your broker, from any exchange on which options are traded or by visiting www.OptionsEducation.org.
In order to simplify the computations used in the examples in these materials, commissions, fees, margin interest and taxes have not been included. These costs will impact the outcome of any stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences.
Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and should not be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results. ©2018 The Options Industry Council. All rights reserved.

The Options Industry Council (OIC) and Saxo Bank
The Options Industry Council (OIC) and Saxo Bank both invest heavily in their online education initiatives, which enable investors to increase their option knowledge and skills using accessible and easily digested content. For OIC’s comprehensive website go to www.OptionsEducation.org.


Saxo Bank’s educational material can be found here
 
About The Options Industry Council (OIC)
Celebrating its 25th anniversary, OIC is an industry resource funded and managed by OCC, the world’s largest equity derivatives clearing organization. Its mission is to provide free and unbiased education to investors and financial advisors about the benefits and risks of exchange-listed equity options. OIC offers education which includes webinars, podcasts, videos, seminars, self-directed online courses, mobile tools, and live help. OIC's Roundtable is the independent governing body of the Council and is comprised of representatives from the exchanges, member brokerage firms and OCC. For more information on the educational services OIC provides for investors, visit www.OptionsEducation.org.



19 March
Garinem Garinem
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