What is 'Out Of The Money - OTM'
Out of the money (OTM) is term used to describe a call option with a strike price that is higher than the market price of the underlying asset, or a put option with a strike price that is lower than the market price of the underlying asset. An out of the money option has no intrinsic value, but only possesses extrinsic or time value.
BREAKING DOWN 'Out Of The Money - OTM'The value of an out of the money option erodes quickly with time as it gets closer to expiry. If it still out of the money at expiry, the option will expire worthless.
The Basics of Options
For a small premium, stock options give the purchaser the right, but not the obligation, to purchase 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 purchase stock is known as a call option, while an option to sell stock is called a put option. Therefore, a trader would purchase a call option if he expects the stock's trading price to exceed the strike price before the expiration date, as he can execute the option and profit on the difference. Conversely, a put option enables the trader to profit on a similar decline in the stock's trading price.
Because they derive their value from that of an underlying security, options are a type of financial derivative.
Out of the Money, In the Money, or At the Money
Consider a stock that is trading at $10. For such a stock, call options with strike prices above $10 would be out of the money calls, while put options with strike prices below $10 would be out of the money puts. Out of the money options are significantly cheaper than in the money or at the money options, and offer the biggest leverage or bang for the buck if the option trader's view proves to be correct.
In the case of a stock that is trading at $30, a one-month call with a $29 strike may be priced at $1.50, while a one-month call with a $31 strike may be priced at 40 cents. If the stock appreciates to $31 by option expiry, the $29 call would be trading at about $3, while the $31 call would be priced around $1. In this case, the gross return of 150% for the $31 call is well above the 100% return for the $29 call.