Key Takeaways
- OTM options have no intrinsic value.
- Call OTM if market price below strike.
- Put OTM if market price above strike.
- OTM options cost less but risk total loss.
What is Out Of The Money (OTM)?
Out Of The Money (OTM) refers to options that currently hold no intrinsic value because the underlying asset's market price does not favor exercising the option. For call options, this means the asset price is below the strike price, while for put options, it is above the strike price.
Although these options lack immediate exercise value, they may still have time value reflecting potential future price movements before expiration.
Key Characteristics
OTM options have distinct features that influence their pricing and risk profile:
- No intrinsic value: Exercising an OTM option is unprofitable since the strike price is less favorable than the current market price.
- Time value only: OTM options derive value solely from time left until expiration and implied volatility.
- Lower premiums: Compared to in-the-money options, OTM contracts generally cost less due to higher likelihood of expiring worthless.
- High leverage potential: Small movements in the underlying can lead to large percentage gains if the option moves into the money.
- Associated risks: Buyers risk losing the entire premium if the option remains OTM at expiry.
- Related concepts: Understanding margin requirements is important when trading OTM options.
How It Works
When you purchase an OTM call option, you have the right but not the obligation to buy the underlying asset at the strike price, which currently exceeds the market price. Exercising such an option immediately would mean paying more than the asset's value, making it unfavorable.
Similarly, an OTM put option gives you the right to sell at a strike price below the market price, which is also unprofitable to exercise immediately. Traders buy OTM options speculatively, betting on significant price movements to push the option into the money before expiration.
Examples and Use Cases
Understanding OTM options in real-world contexts helps clarify their practical use:
- Technology stocks: An OTM call option on Apple with a strike price above the current market price allows investors to speculate on a future price increase while limiting upfront cost.
- Electric vehicles: Investors may buy OTM puts on Tesla to hedge against potential downside risks or to speculate on price declines.
- Broad market exposure: An OTM call on the SPY ETF offers leveraged exposure to market rallies with a lower premium than at-the-money options.
Important Considerations
Trading OTM options requires awareness of their risk and reward profile. While low premiums offer high leverage, the probability of expiration worthless is also high, making them a speculative tool rather than a consistent income source.
You should also factor in the impact of operating leverage in your portfolio and the potential benefits of early exercise in some scenarios, though this is rare for OTM options. Effective risk management and an understanding of option pricing dynamics are essential when incorporating OTM options into your trading strategy.
Final Words
Out-of-the-money options carry no intrinsic value and risk expiring worthless, but they can offer strategic opportunities based on time value and market movement. Evaluate the cost versus potential payoff carefully before adding OTM options to your portfolio.
Frequently Asked Questions
Out Of The Money (OTM) options are those where the current price of the underlying asset makes exercising the option unprofitable. For call options, this means the asset price is below the strike price, and for put options, the asset price is above the strike price.
OTM options have no intrinsic value but may still have time value due to the potential for the underlying asset price to move favorably before expiration. However, if they remain OTM at expiry, they expire worthless.
Since OTM options lack intrinsic value, their premiums are lower compared to in-the-money or at-the-money options. This lower cost offers traders high leverage but comes with a higher risk of expiring worthless.
A call option is OTM when the market price of the asset is below the strike price, making buying at the strike price more expensive than the market. Conversely, a put option is OTM when the market price is above the strike price, making selling at the strike price less profitable than the market price.
At expiration, OTM options have zero intrinsic value and expire worthless. Buyers lose the premium paid, while sellers keep the premium without any further obligation.
Traders often buy OTM options speculatively to benefit from significant price moves in the underlying asset. These options are cheaper and can offer high returns if the asset price moves enough to push the option in-the-money before expiration.
OTM options carry a high risk because they are less likely to become profitable and often expire worthless, causing buyers to lose the entire premium paid. They require significant price movements to become valuable.
