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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