Out of the Money: Definition and Meaning

Ever snagged a cheap theater ticket, only to find your seat is way in the back? 

In the world of options trading, going for an “Out of the Money” (OTM) option is similar. These options are less costly because their value isn’t as immediately apparent as pricier alternatives.

For call options, OTM means the strike price exceeds the market price of the underlying asset. In the case of put options, it’s OTM if the strike price is less than the market value. These options, akin to back-row seats, may seem less attractive but can offer significant potential gains if the market moves favorably.

Grasping the nuances of OTM options is crucial for traders, as it influences strategies and risk-reward balances. Like choosing a discounted theater seat, picking an OTM option involves careful timing and insight, hoping for a payoff worth the risk.

To fully grasp this strategic element of trading, let’s begin with the ABCs of options, diving into the basics of options.

The ABCs of Options Trading

Options trading, a derivative trading method, empowers traders to buy or sell the right (not the obligation) to buy or sell an underlying asset at a set price within a certain timeframe. Its appeal lies in the flexibility it offers, marking it as a popular investment tactic.

Options come primarily in two forms: call options and put options. A call option allows the trader the right to buy an asset at a predetermined price, the strike price, before the option’s expiration. On the flip side, a put option authorizes the trader to sell an asset at the strike price before it expires. The option’s premium, or the price paid for the option, signifies the contract’s cost.

In options trading, traders typically adopt one of four positions: buying a call, selling a call, buying a put, or selling a put. Each stance carries distinct risks and potential gains. Traders can combine these positions in various ways to construct strategies that match their market views and risk appetite.

At its core, options trading provides a dynamic platform for traders to safeguard investments, earn income, or predict the price movements of an asset. This approach caters to a variety of trading styles and goals, offering a broad spectrum of possibilities. 

Unpacking the Term: Out of the Money (OTM)

In the dynamic world of options trading, understanding an option’s moneyness — whether it’s In the Money (ITM), At the Money (ATM), or Out of the Money (OTM) — is key to strategic decision-making. OTM refers to an options contract that currently holds no intrinsic value, meaning it would result in a loss if exercised immediately. The moneyness of an option, including its OTM status, primarily depends on the option’s strike price relative to the existing market price of the underlying asset. 

For a call option, granting the right to buy the asset at a set strike price, the OTM designation applies when this strike price exceeds the asset’s market price. Take, for instance, a call option with a $50 strike price when its stock trades at $45. It falls into the OTM category, as exercising it would mean purchasing the stock above its market value.

In contrast, a put option allows the holder to sell the asset at a predetermined strike price. It’s considered OTM if this strike price falls below the asset’s market value. For example, if the market price is $45, but the put option’s strike price is $40, the option is OTM, indicating a potential loss since it would entail selling the stock below its current value.

Despite this, OTM options attract traders due to their lower cost compared to in-the-money options, offering a more budget-friendly strategy for speculating on future price movements. The caveat? There’s a notable risk of these options expiring worthless, resulting in a total loss of the initial premium paid for the contract.

Exploring the Essentials of OTM Options 

Options trading encompasses a range of strategies that allow investors and traders to adeptly handle diverse market scenarios. A key component in this toolkit is the understanding of OTM options, which are vital for savvy decision-making.

The classification of an OTM option is based on its strike price’s relationship with the current market price of the underlying asset. Specifically, for call options, the OTM status means the strike price is above the market price. For put options, it’s the reverse, where the strike price is below the market value. In either case, the intrinsic value of an OTM option is nil since exercising it at the market price wouldn’t yield a profit.

But it’s not to say that OTM options are valueless. Their premium comprises mainly the “time value” – the potential of the option turning profitable before it expires. Influenced by factors like market volatility, the remaining time to expiration, and prevailing interest rates, this time value diminishes as the option nears its expiry, a process known as time decay, or theta decay. This aspect is crucial for traders and investors, shaping the likelihood of an option’s profitability.

OTM options also stand out for their affordability relative to in the money (ITM) options, offering a cost-effective route for speculating on future price directions of assets. Yet, this comes with a caveat – a heightened risk of the options expiring worthless.

Additionally, OTM options are integral to various strategic plays in trading, such as spreads and combinations. These strategies involve pairing OTM options with other types of contracts, allowing traders to tailor positions to fit their risk preferences and market predictions. Through such strategies, OTM options serve as versatile tools in crafting risk-managed and potentially profitable trading approaches.

A Real-World Scenario: OTM Options in Action

Imagine Toyota Motors (TM), renowned for its automotive innovations, with shares trading at $175 each. An investor believes that Toyota’s stock will rise following the company’s announcement to double down on their EV investment. Expecting a boost in stock value, the investor purchases a call option with a $180 strike price, set to expire in a month. This option is OTM as its strike price is higher than Toyota’s current share price, thus attracting a lower premium than an ITM option.

Two weeks later, Toyota’s stock jumps to $190, driven by positive investor response and promising developments in their EV segment. The initial OTM option has now shifted to being ITM, holding an intrinsic value of $10 — the difference between the current $190 share price and the $180 strike price. As a result, the option’s premium has significantly increased, presenting the investor with an opportunity to sell for a profit.

However, the investor decides to wait for an even higher increase in the stock price. Unfortunately, this risk doesn’t pay off. Following an unexpected delay in EV production, Toyota’s stock declines to $182. As the option’s expiration date draws near and with time value diminishing, the option is perilously close to becoming worthless, unless Toyota’s stock price can climb back above the $180 strike.

This scenario vividly illustrates the dynamic and high-risk nature of trading OTM options. While they offer a less expensive entry point for betting on stock movements, they also carry a substantial risk of expiring without value. For traders, judiciously balancing market acumen and proper risk management is crucial in the unpredictable domain of OTM options trading. 

OTM vs. ITM: A Comparative Study

Options trading brings to light two primary positions – OTM and ITM options, each bearing distinct characteristics and suited to different trading strategies.

At the core, OTM and ITM options differ in how their strike prices compare to the stock’s current price. OTM options have strike prices that don’t currently benefit the holder; for calls, the strike price is higher than the stock price, and for puts, it’s lower. ITM options, however, are those with strike prices that favor the holder – lower for call options and higher for put options.

The key aspect of intrinsic value also separates OTM from ITM options. OTM options lack intrinsic value due to their unfavorable strike price relative to the current stock price. They are often less expensive, attracting those who speculate or have strong convictions about market movements. ITM options, carrying intrinsic value, are more costly but offer a higher probability of profit, aligning with the goals of more cautious traders looking to limit risk.

Time decay plays a pivotal role in the value of both OTM and ITM options. OTM options are more susceptible to time decay, risking total loss of value if they remain OTM at expiration. ITM options, while still affected by time decay, are buffered by their intrinsic value.

In summary, OTM options, with their lower costs, appeal to speculative traders willing to take on greater risks of expiring worthless. ITM options, priced higher due to their intrinsic value, provide a safer route for more conservative traders. The selection between OTM and ITM options ultimately hinges on the trader’s market perspective, risk appetite, and trading goals, making it a crucial consideration in crafting a tailored options trading strategy. 

Unraveling the Relationship Between OTM and Option Premium

Option premiums, shaped by factors like intrinsic value, time value, volatility, and interest rates, reveal a particularly intriguing interplay in the case of OTM options. These options stand out due to their absence of intrinsic value and their reliance on time value.

With no intrinsic value — the disparity between the option’s strike price and the current stock price — OTM options for calls have strike prices above the stock price, while puts have strike prices below. Therefore, an OTM option’s premium is solely composed of its time value and the implied volatility. The time value, reflecting the prospect of the option shifting ITM before expiry, gradually fades as the expiration date draws near, an effect known as time decay.

Market volatility significantly sways the premium of OTM options. Increased volatility enhances the chances of an option moving ITM, potentially hiking up its premium. In tranquil market scenarios, the opposite effect can occur, with premiums dipping. Unlike recently, with the S&P on track to a three-month losing streak, market tranquility isn’t always the norm. A critical takeaway is the sensitivity of OTM option premiums to market dynamics, which are affected by both stock price movements and fluctuations in volatility. This sensitivity underscores the importance of a keen market awareness when dealing with OTM options.

Navigating the Outcome of Options Expiring OTM

When options expire OTM, it implies that exercising the option isn’t advantageous for the holder, failing to yield a profit. Specifically, a call option falls into this category if the underlying asset’s price stays below the strike price at expiration, while a put option does so when the asset’s price is above the strike price.

For the individual holding the option, such an OTM expiration equates to losing the entire premium paid for acquiring the option. This loss results from the option’s lack of intrinsic value at expiry, rendering it valueless. Notably, the holder’s financial risk is confined to the amount of the premium.

Conversely, the outcome is more favorable for the option seller or writer. When an option expires OTM, the seller reaps the benefit of retaining the full premium paid by the buyer, marking a profit. This ideal scenario for sellers means no obligation to execute the contract, given the holder’s disincentive to exercise the option.

Despite the risk of total premium loss, OTM options continue to draw traders, primarily because of their lower premiums relative to ITM or ATM options. Their affordability makes them an attractive strategy for traders who speculate on substantial shifts in the price of the underlying asset. 

Out of the Money Pros and Cons

OTM options carry a distinct set of benefits and drawbacks, which traders need to evaluate thoroughly.

Pros

• Affordable Premiums: OTM options are generally more budget-friendly than ITM or ATM options. This affordability appeals to traders with limited funds or those aiming to reduce their risk exposure.
• Enhanced Potential for Returns: Given their lower initial cost, OTM options can yield higher percentage gains if the underlying asset’s price moves favorably. This potential for sizable returns attracts traders who are comfortable with elevated risk for the chance of greater rewards.
• Versatility in Trading Strategies: Traders often employ OTM options in diverse strategic contexts, such as hedging or speculating on market trends. These options provide the versatility needed for crafting intricate, risk-adjusted trading approaches.

Cons

• Increased Risk of Becoming Worthless: The primary downside of OTM options is their heightened likelihood of expiring without value. If the price of the underlying asset doesn’t sufficiently rise (for call options) or fall (for put options) beyond the strike price, the trader may lose the entire premium.
• No Intrinsic Value: OTM options lack intrinsic value. Their worth hinges solely on time value and market volatility, making their pricing more susceptible to shifts in these elements.
• Impact of Time Decay: All options face time decay, but it’s particularly acute for OTM options, which consist only of extrinsic value. As expiry nears, time decay can significantly diminish the value of these options, even when the underlying asset’s price doesn’t change.

OTM options offer a cost-effective way for traders to speculate on market movements, with their lower premiums paving the way for potentially higher relative returns despite their higher risk of expiring worthless. The suitability of these options hinges on a trader’s willingness to absorb risk, understand market dynamics, and strategize accordingly. 

Conclusion

In conclusion, out of the money (OTM) options present a distinctive balance between affordability and potential for high returns, making them a magnet for traders who are comfortable with taking calculated risks. Their lower upfront cost is a key attraction, offering an avenue for traders to speculate on significant market moves without the substantial capital required for other option types. However, the charm of these options comes with the caveat of a higher likelihood of expiring worthless, a risk that demands a thorough understanding of market dynamics and the inherent behavior of the underlying assets. 

Traders must weigh the potential of outsized gains against the risk of total premium loss. Ultimately, the decision to utilize OTM options should be guided by an individual’s risk tolerance, depth of market insight, and strategic foresight in trading. They aren’t a one-size-fits-all solution but can be a powerful tool in the hands of a well-informed trader. Prior to venturing into the domain of OTM options, it’s advisable to seek expert financial advice and engage in comprehensive market research, ensuring that every move aligns with personal investment goals and trading strategies.

Out of the Money: FAQs

How Do OTM Options Differ from ATM Options?

OTM and ATM options vary mainly in their strike prices relative to the underlying asset’s current market price. OTM options have strike prices that are less favorable, with no intrinsic value, while ATM options have strike prices equal to or very close to the market price, verging on intrinsic value. Due to the increased risk of expiring worthless, OTM options typically command lower premiums than ATM options.

What Determines if an Option is Classified as OTM?

An option is categorized as OTM based on the relationship between its strike price and the current market price of the underlying asset. For call options, it’s OTM if the strike price is above the market price; for put options, if it’s below. This status can also be affected by factors like the time remaining until expiration, the asset’s implied volatility, and general market conditions.

Are OTM Options Always Less Attractive than ITM Options?

Not always. Although ITM (In the Money) options have intrinsic value and carry lower risk, they also have higher premiums, potentially limiting profits. Conversely, OTM options, while riskier and more prone to expire worthless, are cheaper and can offer greater percentage returns. The choice between OTM and ITM options depends on the trader’s risk tolerance, market perspective, and trading strategy.

How can Traders Effectively Utilize OTM Options in Their Strategies?

Traders can use OTM options to bet on substantial price moves of an underlying asset with a smaller capital investment. They are also useful in complex trading strategies like debit and credit spreads or combinations, providing opportunities to maximize profits while controlling risks.

What Occurs with the Premium of an OTM Option at Expiration?

If an option expires OTM, it becomes worthless, resulting in the loss of the entire premium paid by the trader. This risk is a fundamental aspect of trading OTM options, and traders need to be prepared for the possibility of losing their full investment in these scenarios. To better ensure the protection of this premium, employing options alerts can be beneficial, alerting traders to critical market movements or changes in their option’s status, thus allowing for timely decisions that could mitigate potential losses.