In the Money versus Out of the Money
Course: Investment Planning
Lesson 3: Equity Securities
Student Question:
Hi Bruce,
In reviewing the tax implications of derivatives, I had a question about the terms in & out of money.
Is premium price factored into whether something is in or out of money? Or is it strictly referring to market and strike price?
Thanks,
Instructor Response:
Great question Lafe. And one of the CFP Board’s favorite tricks.
If I have positive cash flow at exercise, I’m in the money. If my positive cash flow is greater than the premium I paid, I’ve made a profit.
Quick example:
Jane Deaux paid $2/share for a 90-day $40 call option contract on KO when KO was trading at $39/share.
- The option is out of the money if she exercised immediately. She’d have negative cash flow of $1/share.
60 days later, KO was trading at $45/share.
Jane exercises her $40 call.
- She is in the money $5/share.
- She paid $40/share for a security trading at $45/share.
- She also has a profit of $3/share.
- She paid $2 premium for a stock that is in the money $5/share.
“Profit” and “in the money” are not synonyms.
Let me know if you have any other questions here.
Bruce
