What is Out Of The Money (OTM)?
Out of the money (OTM) is a 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.
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.
Understanding Out Of The Money Options
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.
Out of the Money (OTM) 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.
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.
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 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.
Out of the Money (OTM) 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.
Upon buying the option, 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 $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).