What is out of the money?

An option contract is 'out of the money' (OTM) when its strike price is unfavorable compared to the underlying asset's current market price, meaning exercising the option immediate

In the world of options trading, the term 'out of the money' (OTM) is fundamental to understanding an option's potential profitability and the likelihood of its exercise. An option is considered OTM when its intrinsic value is zero. For a call option, which gives the holder the right to buy an asset, it is out of the money when the strike price (the price at which the asset can be bought) is higher than the current market price of the underlying asset. For example, if a stock trades at $50, a call option with a $55 strike price would be OTM because buying at $55 when you could buy in the market for $50 makes no financial sense. Conversely, for a put option, which grants the right to sell an asset, it is out of the money when the strike price (the price at which the asset can be sold) is lower than the underlying asset's current market price. Using the same example, if a stock trades at $50, a put option with a $45 strike price would be OTM because selling at $45 when you could sell in the market for $50 is not beneficial.

The significance of an option being out of the money is that it possesses no intrinsic value. Its entire value is derived solely from its time value and implied volatility. As an option approaches its expiration date, its time value erodes, and if the underlying asset's price does not move favorably, an out of the money option will likely expire worthless. This is why OTM options are often cheaper than in-the-money or at-the-money options, as they carry a lower probability of becoming profitable. Buyers of OTM options are typically speculating on a significant price movement in the underlying asset before expiration, hoping their option will move into the money. Sellers of OTM options, on the other hand, often collect premium with the expectation that the option will expire worthless, allowing them to keep the premium.

Why it matters

Common mistakes

- Misunderstanding the probability of OTM options becoming profitable is a common error. Many new traders may be drawn to the low cost of OTM options without fully comprehending that their low cost reflects a lower likelihood of exercising at expiration.
Overleveraging with OTM options can lead to significant losses. Because OTM options are cheaper, some traders might buy a larger number of contracts, amplifying potential losses if the options expire worthless, which is a frequent outcome.
Neglecting the impact of time decay (theta) on out of the money options can be costly. As OTM options have no intrinsic value, their entire premium consists of time value, which erodes rapidly as expiration approaches, especially in the final weeks.

FAQs

What is the main difference between in-the-money and out-of-the-money options?

The main difference lies in their intrinsic value. In-the-money options have intrinsic value and would be profitable if exercised immediately, whereas out-of-the-money options have no intrinsic value and would result in a loss if exercised immediately.

Do out-of-the-money options ever have value?

Yes, out-of-the-money options always have extrinsic value (time value and implied volatility) as long as there is time remaining until expiration. This extrinsic value reflects the possibility that the option could move into the money before it expires.

Why would someone buy an out-of-the-money option?

Traders often buy out-of-the-money options because they are less expensive and offer high leverage. They are typically speculating on a significant and rapid price movement in the underlying asset, hoping for a large percentage gain if their directional bet is correct before expiration.