In the money, out of the money, breakeven

Two different questions about the same price

Moneyness asks whether exercising would be worth doing right now, ignoring what the option cost. A call is in the money when the stock is above the strike, because buying at the strike beats buying in the market. A put is in the money when the stock is below the strike, because selling at the strike beats selling in the market. At the strike, either option is at the money.

Intrinsic value is the size of that advantage. For a call it is the market price minus the strike; for a put it is the strike minus the market price. Intrinsic value never falls below zero, because nobody exercises an option that makes them worse off. Anything the option is worth beyond its intrinsic value is time value, which reflects the time remaining until expiration.

Breakeven asks a different question: at what price does the buyer stop losing money on the whole trade? That has to include the premium, because the premium was spent whatever the stock does. A call buyer needs the stock above the strike by at least the premium, so breakeven is strike plus premium. A put buyer needs it below the strike by at least the premium, so breakeven is strike minus premium.

The two questions produce different answers on purpose, and the gap between them is where most wrong answers live. A call with a $40 strike bought for $2 is in the money the moment the stock passes $40 and still loses money for the buyer until it passes $42. Both statements are true at $41, and a question will ask you which one it wants.

The disclosure document splits the premium the same way and is worth quoting for the edge cases. Intrinsic value reflects the amount, if any, by which the option is in the money, and an option that is out of the money has an intrinsic value of zero — never a negative number, however far out of the money it goes. Time value is that part of the premium which reflects the time remaining before expiration, so an out-of-the-money option that still has a price is being priced entirely on time. Its own worked example: with the stock at $46, an XYZ 40 call has an intrinsic value of $6 a share; at $44 it is $4; at $40 or below the call has no intrinsic value at all.

Exam terms

In the money

Exercising now would be better than trading in the market.

At the money

The market price equals the strike price.

Out of the money

Exercising now would be worse than trading in the market.

Intrinsic value

The in-the-money amount; never less than zero.

Time value

Any premium above intrinsic value; it reflects the time remaining to expiration.

Breakeven

The stock price at which the buyer’s whole trade shows neither profit nor loss.

Worked example

A 40 call is bought for a premium of $2 a share, and the stock is examined at three different closing prices.

1. At $38 the call is out of the money. Exercising to buy at $40 when the market offers $38 makes no sense, so the intrinsic value is zero and the buyer lets it expire, losing the $200 premium on the contract.
2. At $41 the call is in the money by $1 a share, so exercising recovers $100 on the contract. The buyer is still down, because $100 recovered against a $200 premium is a $100 loss.
3. Breakeven is the strike plus the premium: $40 + $2 = $42. At exactly $42 the $2 of intrinsic value matches the $2 premium and the trade is flat.
4. At $46 the call is in the money by $6, worth $600 on the contract, against the $200 paid. The profit is $400.
5. Notice that the answer to whether it is in the money changed at $40 and the answer to whether the buyer profited changed at $42. Two questions, two thresholds, two different numbers.

Check yourself

Try a question, then read the explanation to review the rule.

Same rule, new context

Related practice

• Call vs put, buyer vs writerPractice this