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.
Understanding Out Of The Money Options
Breaking Down Out Of The Money (OTM)
Out of the money option premiums erode quickly as the expiration date gets closer. If the option is still OTM at expiry, the option will expire worthless.
The Basics of Options
For a 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 may purchase a call option if they expect the stock price to exceed the strike price before the expiration date. Conversely, a put option enables the trader to profit on a decline in the stock's trading price.
Because they derive their value from that of an underlying security, options are derivatives.
Out of the Money Options
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. For example, assume a trader buys a $20 call option. This gives them the right to buy 100 shares of the stock before the option expires. The stock is currently trading at $19. There is no reason to exercise the option, because by exercising the option they have to pay $20 for the stock, when they can currently buy it at a market price of $19.
If the stock price moves above $20—this is called in the money (ITM)—it is worth exercising the option. The option gives them the right to buy at $20, and the current market price is above that. The difference between the strike price and the current market price is known as intrinsic value.
Just because a stock has intrinsic value does mean the trader necessarily was better off buying the option. Assume our trader above bought the $20 call option for a $2 premium. At expiry the stock is trading at $21. This option will have a value of $1 because it allows the trader to buy at $20 and immediately sell to the market at $21. Yet this would actually result in a $1 loss per share, because the trader bought the option for $2 and only benefited $1.