Realist, not conformist analysis of the latest financial, business and political news

This Isn’t What Out Of The Money Option Means

On Wednesday 2nd November Robin Hood Tax supporters descended on the Houses of Parliament to send off David Cameron to the G20. Backed by the 80,000 people who had emailed the Prime Minister asking him to support a Financial Transaction Tax in Cannes, we gave out leaflets, stickers and a special Robin Hood version of the Financial Times to MPs on their way into work. Ian Mearns MP

The black swan theory of investing came to prominence in 1987 after the Black Monday Wall Street crash. Investors realised that some stock options were not priced correctly: they were being bought and sold on the basis that they would deliver regular returns, when actually, as a result of events such as stock market crashes, many were not.

As a result, traders started to price stocks to take account of wilder swings in the market. These became known as “out of the money” options, because they were valued beyond what traders would typically expect. Opportunists began to scour the globe to find stocks that would deliver spectacular returns should the market fail.

That’s not what out of the money means.

With an option there is the strike price and the market price. An option is an agreement that you may – note, may, not must, if it’s must then it’s a future – buy for a call, sell for a put, a certain thing or stock at a predetermined price at some point in the future. That predetermined price is the strike price or if you prefer, the exercise price.

The market price is, obviously enough, whatever the market price of that thing or stock is right now.

Let us remain with calls just to keep this simple. I have a call option at a strike price of 100 p on summat. If the market price is currently 110p then that is in the money, if 100p, at the money, if at 90p then it’s out of the money. The “money” here being whether I’ve got a profit baked in at the moment or not.

For puts just reverse the prices.

What is being described there as out of the money is to do with time values, risk, fat tails and all that sorta stuff. Which is all fascinating and indeed an opportunity to make pots of money but it ain’t out of the money options.

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