Out-of-the-money (OTM) Options - A Beginner's Guide

Views 6034 Jul 9, 2024

In options trading, the relationship between an option contract's strike price and the current market price of its underlying asset is important. Whether an investor is holding an option contract that's at-the-money (ATM), in-the-money (ITM) or out-of-the-money (OTM), pricing affects all of them.

For this article, we're going to dive into OTM options, learn how pricing affects them and discover the potential pros and cons when using them.

What Does "Out-of-the-Money" Mean

Out-of-the-money call options occur when the strike price is above the market price, and for put options, the strike price is below the market price. OTM options do not have intrinsic value.

So what does OTM mean? It's important to first explain options moneyness. Moneyness refers to an option’s intrinsic value in the market. It provides insight into the relationship between an option’s strike price and the current price of the underlying asset.

Similar to OTM options, ATM options do not have intrinsic value, only time value; however, ITM options do have intrinsic value. This comes as the current price of the underlying asset exceeds the strike price for calls and for put options, the market price is below the strike price.

What Is the Relationship Between an Out-of-the-Money Contract and Its Premium

Since an out of the money option doesn't have intrinsic value, its premium is mainly composed of time value. OTM options don't offer an immediate profit if exercised due to their current unfavorable strike price relative to the underlying asset's market price. Therefore, their premium reflects the market's perception of the likelihood that the option will move into the money before expiration.

In addition, the further an option is from being ITM, the lower its premium tends to be, as the probability of it becoming profitable decreases. Conversely, as an option moves closer to being ITM, its premium can increase due to the higher perceived chance of it yielding a profit.

This dynamic between the strike price's position and its premium underlines the speculative nature of OTM options: investors pay for the potential, rather than the immediate value.

Out-of-the-Money Options

Out-of-the-money (OTM) options would not make money if they were immediately exercised. They have no intrinsic value but may still have time value if there is time remaining until expiration. Remember, the total value of an option is the sum of its intrinsic value and its time value.

Here's a deeper look at OTM calls and OTM puts to gain a greater understanding of what is OTM.

Out-of-the-Money Call Options

An out of the money call option occurs when the strike price is higher than the current market price of the underlying asset. It lacks intrinsic value because the underlying asset’s price is below the option’s strike price; it only has extrinsic value (time value).

Traders can buy OTM call options when they anticipate the underlying asset’s price will rise significantly before the option’s expiration date; however, if the asset’s price doesn’t reach the strike price by expiration, the OTM call option becomes worthless. OTM call options are less expensive than in-the-money (ITM) or at-the-money (ATM) call options.

Out-of-the-Money Put Option

An out of the money put option is an option contract where the strike price is lower than the current market price of the underlying asset. An OTM put option lacks intrinsic value because the underlying asset’s price is above the option’s strike price; it only has extrinsic value (also known as time value).

A trader may buy OTM puts for a few reasons. This can include speculating on price declines for the underlying asset, hedging to protect against price declines and paying a lower cost to enter a trade as OTM optons have lower premiums as compared to in-the-money options.

Out-of-the-Money Options Examples

Here are some examples of an OTM call option and an OTM put option to help demonstrate the OTM meaning.

OTM call: A stock currently trades at $40 per share. An OTM call option with a strike price of $50 is considered OTM because the current stock price is below the strike price. If the stock price doesn’t reach more than $50 by expiration, the OTM call option expires worthless.
OTM put: A stock currently trades at $40 per share. An OTM put option with a strike price of $30 is considered OTM because the stock price is above the strike price. If the stock price doesn’t fall below $30 by expiration, the OTM put option expires worthless.

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Potential pros and cons

Whether it's an in-the-money or out-of-the-money option, both come with their own set of pros and cons. Below is a table illustrating the potential pros and cons of OTM options. We'll talk about the differences between ITM and OTM options in the next section.

Potential Pros

Potential Cons

Buyer side

Undergo cheaper premiums as compared to ITM options for the same underlying stock. When purchasing an OTM contract, it has no intrinsic value. The costs to enter into the trade is lower.

Potentially offers leverage. If the stock moves in your favor, the lower initial cost provides significant leverage.

Risk of options expiring worthless. OTM options require the market price to move beyond the strike price. Any insufficient market movement before expiration can lead to the option having no intrinsic value, resulting in the loss of the entire premium paid by the buyer.
Affected by changes in implied volatility The price of OTM puts can be affected by changes in implied volatility. A decrease in volatility can lead to a decrease in the option's price--even if the stock moves in the anticipated direction.

Seller side

Generate income through premiums Selling puts enables you to generate income while waiting for the stock to potentially reach a favorable buying price.
Endure higher probability of profit Since OTM puts have a lower delta compared to at-the-money or in-the-moey puts, there's a higher probability that these options will expire worthless, allowing the seller to keep the entire premium as profit.
Greater flexibility Selling OTM puts can be used as part of a broader investment strategy, such as portfolio diversification or hedging, giving investors additional tools to manage their investments.

Endure risk of unexpected market moves If the price of the underlying asset swings beyond the strike price, the seller is obligated to fulfill the contract. This could result in substantial losses, especially if the seller doesn't own the underlying asset (a scenario known as "naked" on the option).
Deal with lower premiums While OTM option premiums might provide a steady income stream, they are generally lower than those from options closer to the money. Sellers must balance the potential income against the risk of a significant loss if the market moves unfavorably.
Conduct continuous market assessment and potential adjustments When maintaining a strategy focused on selling OTM options, this requires continuous market assessment and potentially frequent adjustments to positions to help mitigate risks. This can be time-consuming and requires an understanding of market movements and sentiment.

Out-of-the-money vs. In-the-money options: What's the difference

In options trading, understanding the difference between in the money (ITM) and out of the money (OTM) is crucial. This can affect trading strategy, timing, and goals. Let’s break it down by comparing the two in five areas.

Strike price: An ITM option's strike price has already been surpassed by the current stock price whereas an OTM option's has a strike price that the underlying security has yet to reach.
Intrinsic value: ITM options possess intrinsic value, enabling the option holder to buy or sell the underlying asset with the potential for profit. OTM options lack intrinsic value and are priced mainly based on extrinsic factors like time decay and implied volatility.
Pricing: ITM options are priced higher than OTM options in the same chain. With OTM options being less costly than ITM options, it may appeal to traders with smaller capital who still want to participate in the market.
Uses: ITM options are often used for hedging, partial hedging, or when traders want intrinsic value, not just time value. OTM options strategies are commonly used for strategies like covered calls or protective puts.
Price moves: As ITM options have intrinsic value and when in the same chain, they're priced higher than OTM options. The price moves (in percentage) of ITM options are relatively smaller as compared to OTM options.