Deep out of the money: Meaning, Criticisms & Real-World Uses

What Is Deep Out of the Money?

"Deep out of the money" (DOTM) describes an options contract that has a strike price significantly far from the current market price of its underlying asset. This state implies a very low probability of the option expiring "in the money" and thus having intrinsic value before its expiration date. Deep out of the money options are a key concept within options trading, a specialized area of derivatives.

For a call option, an option is deep out of the money when its strike price is substantially higher than the current stock price. Conversely, for a put option, it is deep out of the money when its strike price is significantly lower than the current stock price. These options typically trade at a very low premium, primarily composed of time decay value rather than intrinsic value.

History and Origin

The concept of "deep out of the money" options emerged naturally with the formalization and expansion of options markets. Before the 1970s, options were primarily traded over-the-counter, with varying terms and limited transparency. The establishment of the Chicago Board Options Exchange (CBOE) in 1973 revolutionized options trading by introducing standardized, exchange-traded stock options. This innovation allowed for greater liquidity, transparency, and accessibility, enabling market participants to observe and categorize options based on their relationship to the underlying asset's price.⁷,

As the market matured and more sophisticated pricing models developed, the nuances of an option's moneyness, including the distinction of being "deep out of the money," became more defined. The CBOE played a pivotal role in this evolution, continuously expanding its product offerings and refining the market structure for derivatives.⁶

Key Takeaways

Deep out of the money (DOTM) options have a strike price far from the underlying asset's current market price.
They carry a very low probability of expiring in the money.
The premium of DOTM options is minimal, primarily reflecting time value.
Investors often use DOTM options for speculative purposes or as part of complex options strategies.
High leverage and potential for 100% loss of premium are significant characteristics.

Formula and Calculation

While there isn't a direct "deep out of the money" formula, the concept relates to an option's moneyness, which is determined by comparing the strike price ((K)) to the current underlying asset price ((S)).

For a call option:
An option is deep out of the money if (K \gg S).

For a put option:
An option is deep out of the money if (K \ll S).

The premium of an option is typically determined by factors such as the underlying asset's price, strike price, time to expiration, implied volatility, interest rates, and dividends. The Black-Scholes model is a widely used theoretical framework to price options.

Interpreting the Deep out of the Money

Interpreting deep out of the money options requires understanding their inherent characteristics and the market's expectations. When an option is deep out of the money, it signals that the market anticipates the underlying asset will need to make a significant move in price for the option to become profitable. The exceptionally low premium associated with these options reflects this low probability.

For a call option, a deep out of the money strike price suggests that the underlying stock must experience a substantial upward surge before the call option gains intrinsic value. Similarly, for a put option, a deep out of the money strike price indicates that the underlying asset must suffer a significant decline. The minimal cost of these options can make them attractive for highly speculative bets, where a small investment could theoretically yield a large percentage return if the unlikely event occurs. However, it is far more common for these options to expire worthless. Investors often consider market volatility and news events when assessing the potential for such large price movements.

Hypothetical Example

Consider a company, Tech Innovations Inc. (TII), whose stock is currently trading at $100 per share. An investor is looking at TII options with an expiration date three months away.

Scenario 1: Deep out of the money Call Option
An investor considers buying a TII call option with a strike price of $130. Since the stock is at $100, the stock would need to rise by $30 (a 30% increase) just to reach the strike price. This option would be considered deep out of the money. The premium for such an option might be very low, perhaps $0.20 per share. If TII's stock price somehow soared to $135 by expiration, the option would be in the money by $5, and the investor would profit significantly relative to their small initial outlay. However, if the stock remains below $130, the option expires worthless, and the investor loses the entire $0.20 premium paid.
Scenario 2: Deep out of the money Put Option
Alternatively, an investor considers buying a TII put option with a strike price of $70. The stock is at $100, meaning it would need to fall by $30 (a 30% decrease) to reach the strike price. This put option is deep out of the money. Its premium might also be very low, perhaps $0.15 per share. If TII's stock price plummeted to $65 by expiration, the option would be in the money by $5, again offering a substantial percentage return. However, if the stock stays above $70, the option expires worthless, and the investor loses the $0.15 premium.

This example illustrates the "all or nothing" nature often associated with deep out of the money options, where a small investment can either yield a large percentage gain or a complete loss.

Practical Applications

Deep out of the money options, despite their low probability of success, have several practical applications in investing and risk management for sophisticated traders. They are frequently used for highly speculative strategies. For instance, a trader who believes a significant, unexpected event (often called a "black swan" event) could drastically move an underlying asset's price might buy deep out of the money options. Because of their low cost, these options offer substantial leverage.

Another application is in hedging strategies, though less common for deep out of the money options specifically. However, elements of deep out of the money option characteristics can be seen in broader hedging tactics involving derivatives. Some institutional investors might also sell deep out of the money options to collect the small premiums, a strategy known as "selling premium," which aims to profit from the high probability that these options will expire worthless. However, this strategy carries uncapped risk if the unlikely event does occur. It's important to note that retail investors, particularly those new to options, often face significant challenges when trading options, with academic research indicating potential losses for this group.⁵ The Securities and Exchange Commission (SEC) also provides investor alerts about the complexities and risks involved in options trading.⁴ Financial market data and news, often provided by services like Reuters, can influence the perceived likelihood of an option moving in or out of the money.³

Limitations and Criticisms

The primary limitation of deep out of the money options is their extremely low probability of profitability. While they offer high leverage and the potential for substantial percentage returns on a small investment, the vast majority expire worthless. This makes them essentially a bet against the market's current expectations, which is often a losing proposition over the long term.

Critics often highlight the speculative nature of trading deep out of the money options, comparing it to gambling. For individual investors, the potential for losing 100% of the invested premium is a significant drawback. Furthermore, these options typically have wider bid-ask spreads and lower liquidity compared to "at the money" or "in the money" options, making it harder to enter and exit positions efficiently. Regulatory bodies like the SEC frequently issue warnings about the inherent risks of options trading, emphasizing that options can be complex and are not suitable for all investors.²,¹ Studies on retail options trading often underscore the difficulties faced by individual investors in consistently profiting from these instruments.

Deep out of the Money vs. Out of the Money vs. In the Money

The terms "deep out of the money," "out of the money," and "in the money" all describe an option's moneyness, which indicates its relationship between the strike price and the underlying asset's current price.

In the Money (ITM): An option is in the money if exercising it immediately would result in a profit. For a call option, this means the underlying asset's price is above the strike price. For a put option, the underlying asset's price is below the strike price. ITM options have intrinsic value.
Out of the Money (OTM): An option is out of the money if exercising it immediately would not result in a profit. For a call option, this means the underlying asset's price is below the strike price. For a put option, the underlying asset's price is above the strike price. OTM options have no intrinsic value; their entire premium consists of time value and implied volatility.
Deep out of the Money (DOTM): This is a specific classification within "out of the money." A DOTM option is one where the strike price is significantly far from the underlying asset's current price, making the probability of it becoming in the money before expiration very low. For a call, the strike is far above the current price. For a put, the strike is far below the current price. DOTM options have minimal premiums and are highly sensitive to small changes in implied volatility or time decay.

Confusion often arises because "deep out of the money" is a subset of "out of the money." All deep out of the money options are out of the money, but not all out of the money options are deep out of the money. An option might be slightly out of the money, meaning its strike price is close to the current underlying price, and therefore has a higher probability of becoming in the money compared to a deep out of the money option.

FAQs

What does it mean if a call option is deep out of the money?

If a call option is deep out of the money, its strike price is considerably higher than the current market price of the underlying asset. For the option to become profitable, the asset's price would need to increase substantially before the option's expiration. This makes it a high-risk, high-reward proposition.

What does it mean if a put option is deep out of the money?

When a put option is deep out of the money, its strike price is significantly lower than the current market price of the underlying asset. For the option to be profitable, the asset's price would need to fall drastically below the strike price by the expiration date.

Why do investors trade deep out of the money options?

Investors trade deep out of the money options primarily for their high leverage and low cost. A small investment can potentially yield a large percentage return if the underlying asset makes a substantial and favorable price move. This makes them attractive for speculative bets or as lottery-ticket style plays on extreme market events. However, the probability of them expiring worthless is very high, leading to a complete loss of the premium paid.