CSC/DFOL Exam Practice Question

Determine if a call options contract is in the money, at the money, or out of the money. This is a very important video because I’m going to show you a strategy that will make answering these types of questions a snap, and also steer you away from some of the comment pitfalls.

Spoiler alert, the fact that Jackie wrote the options contract doesn’t impact the answer and the premium is also irrelevant. We’ll talk more about why in a minute. There are five nuggets of knowledge that will help you navigate this question. Nugget number one is super important, and it applies to every single question you encounter on options contracts. From this day forward, never tackle an options contract question without having this table written out in front of you so you can refer to it.

Look, I’m an experienced study coach, and even I still use this strategy because it prevents me from getting tricked or confused. It’s just simpler having it in front of me when doing questions like this. I’m confident that once you see how helpful this table is, you’ll be motivated to memorize it so you can jot it down once your real exam begins. When you’re ready, we have a two minute video on YouTube that makes it super easy to remember the table. Nugget number two, when determining if an option is in or out of the money, look at the option itself, not what side of the transaction a particular investor is on. To clarify what I mean by that, and why it’s important, I’m going to tell you a story using an easy to understand analogy. Marco was at work, wanted to buy lunch, but was flat broke.

All he had in his wallet was a lottery ticket for that evening’s draw. Since he was starving, he sold the ticket to Jane for $5 and bought himself a coffee and bagel. That night, the tickets numbers were drawn and Jane won a million dollars. Now, if I ask you, is it a winning lottery ticket? The answer, of course, is yes. Regardless of whether you are Marco who is crying, or Jane who is celebrating, it’s a winning lottery ticket, right? When it comes to whether an options contract is in the money or not, keep that analogy in mind. Much like how we assess the lottery ticket itself as either a winning or losing ticket, we assess the options contract the same way without paying attention to who the holder is or who the writer is. Nugget number three, use the phrase in the money is a good thing to guide you.

As a potential memory aid, I wrestled with singing the well known song we’re in the money with a huge smile on my face, but I’m going to spare your ears, the misery, and myself the embarrassment. I’ll just trust that the phrase in the money is a good thing, makes sense, and is committed to memory. Nugget number four, refer to the question itself and the call put table and fill the blanks in the following sentence. Blank one we fill in with call. Blank two we fill in with buy. Blank three we fill in with $25, and blank four, we fill in with $26. Now that the blanks are filled in, read the sentence and ask yourself, does this seem like a good thing? The call option contract provides the option to buy at an exercise price of $25, and the shares are currently worth $26. An option to buy something for less than what it’s worth sure sounds like a good thing to me.

So let’s select the answer that says the option is in the money, and we are correct. Now to clarify, this will make one investor happy and the other sad, but the question isn’t asking about how anybody is feeling. Finally, nugget number five is a common pitfall so I wanted to mention it. The premium is not a factor when determining if an options contract is in, at, or out of the money. Keep in mind that different investors would’ve paid and/or received different premiums for the same options contract depending on when it was purchased. So the premium is only considered when determining a specific investor’s break-even point. But that’s a whole different concept and a whole different video.