Out-Of-The-Money

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Out Of The Money (OTM)

What Is Out Of the Money (OTM)?

Out of the money (OTM) is a term used to describe an option contract that only contains intrinsic value. These options will have a delta less than 50.0.

An OTM call option will have a strike price that is higher than the market price of the underlying asset. Alternatively an OTM put option has a strike price that is lower than the market price of the underlying asset.

OTM options may be contrasted with in the money (ITM) options.

Key Takeaways

  • Out of the money means an option has no intrinsic value, only extrinsic value.
  • A call option is OTM if the underlying’s price is below the strike price. A put option is OTM if the underlying’s price is above the strike price.
  • An option can also be in the money or at the money.
  • OTM options are less expensive than ITM or ATM options. This is because ITM options have intrinsic value, and ATM options are very close to having intrinsic value.

Understanding Out Of The Money Options

Option Basics

For a premium, stock options give the purchaser the right, but not the obligation, to buy or sell the underlying stock at an agreed-upon price, known as the strike price, before an agreed-upon date, known as the expiration date.

An option to buy an underlying asset is a call option, while an option to sell an underlying asset is a put option. A trader may purchase a call option if they expect the underlying asset’s price to exceed the strike price before the expiration date. Conversely, a put option enables the trader to profit on a decline in the asset’s price. Because they derive their value from that of an underlying security, options are derivatives.

An option can be OTM, ITM or at the money (ATM). An ATM option is one where the strike price and price of the underlying are equal.

Out of the Money Options

You can tell if an option is OTM by determining where the current price of the underlying is in relation to the strike price of that option. For a call option, if the underlying price is below the strike price, that option is OTM. For a put option, if the underlying’s price is above the strike price, then that option is OTM. An out of the money option has no intrinsic value, but only possesses extrinsic or time value.

Being out of the money doesn’t mean a trader can’t make a profit on that option. Each option has a cost, called the premium. A trader could have bought a far out of the money option, but now that option is moving closer to being in the money (ITM). That option could end up being worth more than the trader paid for the option, even though it is currently out of the money. At expiry, though, an option is worthless if it is OTM. Therefore, if an option is OTM, the trader will need to sell it prior to expiry in order to recoup any extrinsic value that is possibly remaining.

Consider a stock that is trading at $10. For such a stock, call options with strike prices above $10 would be OTM calls, while put options with strike prices below $10 would be OTM puts.

OTM options are not worth exercising, because the current market is offering a trade level more appealing than the option’s strike price.

Out of the Money Options Example

A trader wants to buy a call option on Vodafone stock. They choose a call option with a $20 strike price. The option expires in five months and costs $0.50. This gives them the right to buy 100 shares of the stock before the option expires. The total cost of the option is $50 (100 shares * $0.50), plus a trade commission. The stock is currently trading at $18.50.

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Upon buying the option, there is no reason to exercise it because by exercising the option they have to pay $20 for the stock, when they can currently buy it at a market price of $18.50.

This option is OTM, but that doesn’t mean it is worthless yet. The trader just paid $0.50 for the potential that the stock will appreciate above $20 within the next five months.

If the option is OTM at expiry it is worthless, but prior to expiry, that option will still have some extrinsic value which is reflected in the premium or cost of the option. The price of the underlying may never reach $20, but the premium of the option may increase to $0.75 or $1 if it gets close. Therefore, the trader could still reap a profit on the out of the month option itself by selling it at a higher premium than they paid for it.

If the stock price moves to $22—the option is now ITM—it is worth exercising the option. The option gives them the right to buy at $20, and the current market price is $22. The difference between the strike price and the current market price is known as intrinsic value, which is $2.

In this case, our trader ends up with a net profit or benefit. They paid $0.50 for the option and that option is now worth $2. They net $1.50 in profit or advantage.

But what if the stock only rallied to $20.25 when the option expired? In this case, the option is still ITM, but the trader actually lost money. They paid $0.50 for the option, but the option only has $0.25 of value now, resulting in a loss of $0.25 ($0.50 – $0.25).

out-of-the-money

Out-of-the-Money Option

2. A put option with a strike price less than the value of the underlying asset.

In both these situations, the option contract has no intrinsic value. If an option is deep out of the money, it is unlikely that the option will be in-the money by the expiration date. If possible, out-of-the-money options are sold; if not, they expire worthless and the option holder loses the premium.

out-of-the-money

Out-of-the-money.

An option is out-of-the-money when the market price of an instrument on which you hold an option is not close to the strike price.

Call options — which you buy when you think the price is going up — are out-of-the-money when the market price is below the strike price.

Put options — which you buy when you think the price of the underlying instrument is going down — are out-of-the-money when the market price is higher than the strike price.

For example, a call option on a stock with a strike price of 50 would be out-of-the-money if the current market price of the stock were $40.

And a put option at 50 on the same stock would be out-of-the-money if its market price were $60. When an option expires out-of-the-money, it has no value.

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In the Money and Out of the Money Options and Their Intrinsic Value

An option contract’s value fluctuates based on the price of the asset underlying it, such as a stock, exchange-traded fund, or futures contract. The option can be in the money (ITM), out of the money (OTM), or at the money (ATM). Each one of these situations affects the intrinsic value of the option.

The amount of time remaining before the option contract expires also plays a role in the value of the option, which in turn affects how high or low a price—the premium—the buyer is willing to pay for the option.

In the Money

If an option contract is ITM, it has intrinsic value. A call option—which gives the buyer the right but not the obligation to purchase an asset at a set price on or before a particular day—is in the money if the current price of the underlying asset is higher than that agreed-upon price, which is known as a strike price. The buyer could exercise their right under the option contract and buy the underlying asset for less than its current value. That means the call has intrinsic value.

Conversely, a put option—which gives the buyer the right to sell an asset at a set price on or before a particular day—is ITM if the price of the underlying security is lower than the strike price. The buyer could exercise their right under the option contract and sell the underlying asset for more than its current value. That means the put has intrinsic value.

In summary, a call option is a bet that the underlying asset will rise in price sometime before or on a particular day—known as the expiration date—while a put option is a wager that the underlying asset’s price will fall during that time period.

If the strike price of a call option is $5 and the underlying stock is currently trading at $6, the option is ITM. The higher above $5 the price goes, the more ITM the option is and the greater it’s intrinsic value.

If the strike price of a put option is $5 and the underlying stock is currently trading at $4, the option is ITM. The lower below $5 the price goes, the more ITM the option is and the greater it’s intrinsic value.

The intrinsic value of an option that’s ITM is the greater of the strike price or the price of the underlying asset minus the other price. Therefore, the intrinsic value for both the call and put options with the strike price of $5 is $1.

Out of the Money

If an option contract is OTM, it doesn’t have intrinsic value. A call option is OTM if the current price of the underlying asset is lower than the strike price. The buyer of the call option would not exercise their right under the option contract to buy the underlying asset because they would be paying more than its current value.

Conversely, a put option is OTM if the current price of the underlying security is higher than the strike price. The buyer of the put option would not exercise their right under the option contract to sell the underlying asset because they would be receiving less than its current value.

If the strike price of a call option is $5 and the underlying stock is currently trading at $4, the option is OTM. The lower below $5 the price goes, the more OTM the option is.

If the strike price of a put option is $5 and the underlying stock is currently trading at $6, the option is OTM. The higher above $5, the more OTM the option is.

Because these OTM put and call options can not be exercised for a profit, their intrinsic value is zero.

At the Money

If an option contract’s strike price is the same as the price of the underlying asset, the option is ATM. If the strike price of a call or put option is $5 and the underlying stock is currently trading at $5, the option is ATM. Because ATM put and call options can not be exercised for a profit, their intrinsic value is also zero.

Time Value

The value of an option consists of both intrinsic value and time value. The greater the amount of time until an option expires, the more time value it has. That’s because there is a greater chance the option will, at some point, become ITM over the longer time frame before expiration and so have intrinsic value.

When deciding how much of a premium they’re willing to pay, a prospective option buyer must take into consideration whether the underlying asset has or is likely to have intrinsic value and the option’s time value. An option can be OTM and consequently have no intrinsic value but still have time value up until its expiration. If an ITM option has $10 of intrinsic value, the premium should be higher than $10 because of the time value inherent in the amount of time the underlying asset has to become even more ITM.

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