What Is Out of the Money?
An option is considered "out of the money" (OTM) when its strike price has an unfavorable relationship with the current market price of the underlying asset. This means that exercising the options contract would not result in an immediate profit. OTM is a key concept within options trading, a segment of the broader financial category of derivatives. For a call option, it is out of the money if the strike price is above the current market price of the underlying asset. Conversely, for a put option, it is out of the money if the strike price is below the current market price. Options that are out of the money have no intrinsic value, meaning they derive their entire worth from their time value and the potential for the underlying asset's price to move favorably before the expiration date.
History and Origin
The concept of options, and by extension, their moneyness status, has roots stretching back centuries, with early forms of contracts resembling options appearing in ancient Greece to speculate on olive harvests. However, the modern, standardized options contract market emerged with the establishment of the Chicago Board Options Exchange (CBOE) in 197311, 12. Prior to this, options were primarily traded over-the-counter (OTC) with less standardization and liquidity10.
A significant development that revolutionized the valuation of options, including understanding their theoretical value regardless of their moneyness, was the publication of the Black-Scholes model in 1973 by Fischer Black and Myron Scholes9. This mathematical model provided a framework for pricing European-style options, considering factors such as the underlying stock price, strike price, time to expiration, volatility of the underlying asset, and interest rates8. The model's insights facilitated a boom in options trading by offering a quantitative approach to determining a fair premium7. Myron Scholes, along with Robert C. Merton (who further developed the model), received the Nobel Memorial Prize in Economic Sciences in 1997 for their work on the valuation of derivatives6. The Black-Scholes model, by providing a method to estimate an option's theoretical price, helped market participants better assess the risk and reward of trading options, including those that are out of the money.
Key Takeaways
- An "out of the money" (OTM) option means it has no intrinsic value because its strike price is not favorable relative to the current market price of the underlying asset.
- For a call option, OTM occurs when the strike price is above the current asset price. For a put option, OTM occurs when the strike price is below the current asset price.
- The entire value of an out of the money option is composed of its time value, which decays as the expiration date approaches.
- Buyers of OTM options anticipate a significant price movement in the underlying asset to make the option profitable before expiration.
- Sellers of OTM options aim to profit from the decay of the option's time value if the option expires worthless.
Interpreting Out of the Money
An options contract being out of the money signifies that it currently holds no intrinsic value. For a call option, if the current share price of the underlying asset is less than the option's strike price, there is no immediate benefit to exercising the right to buy at the strike price, as one could buy the shares cheaper in the open market. Similarly, for a put option, if the current share price is greater than the strike price, there is no immediate benefit to exercising the right to sell at the strike price, as one could sell the shares for more in the open market.
Despite having zero intrinsic value, an out of the money option can still have a positive premium. This premium is entirely attributed to its time value and the possibility that the underlying asset's price will move sufficiently to bring the option in the money before its expiration date. As the expiration date approaches, this time value erodes, a phenomenon known as time decay.
Hypothetical Example
Consider XYZ Corp. stock currently trading at $50 per share.
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Out of the Money Call Option: You own a call option on XYZ Corp. with a strike price of $55 and an expiration date in one month. Since the current stock price ($50) is below your strike price ($55), this call option is out of the money. If you were to exercise it now, you would pay $55 per share for a stock currently worth $50, resulting in a loss. The option's value comes solely from the possibility that XYZ's stock price will rise above $55 before expiration.
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Out of the Money Put Option: You own a put option on XYZ Corp. with a strike price of $45 and an expiration date in one month. Since the current stock price ($50) is above your strike price ($45), this put option is out of the money. If you were to exercise it now, you would sell shares for $45 that are currently worth $50, resulting in a loss. The option's value relies on the hope that XYZ's stock price will fall below $45 before expiration.
Practical Applications
Out of the money options are frequently utilized in various options trading strategies, particularly for speculation and generating premium income.
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For Buyers: Investors buying OTM options are typically seeking higher leverage and are betting on a significant price movement in the underlying asset. Because OTM options have lower premiums compared to in the money or at the money options, a relatively small upward movement (for calls) or downward movement (for puts) can lead to a substantial percentage gain on the initial premium paid. However, the probability of these options expiring worthless is higher.
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For Sellers (Writers): Selling OTM options contract is a common strategy to collect premium. The expectation is that the option will expire out of the money and worthless, allowing the seller to keep the entire premium received. This strategy is often employed by those who believe the underlying asset's price will remain relatively stable or move in a direction opposite to what would make the option profitable for the buyer. Covered call writing, for example, involves selling OTM call option against shares of stock already owned, generating income while limiting potential upside if the stock rallies.
Financial regulators, such as the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC), oversee the options market to ensure investor protection and market integrity5. They provide educational resources about the risks associated with options trading and the need for investors to understand the complexities involved4.
Limitations and Criticisms
Despite their utility in certain strategies, out of the money options carry significant limitations and risks. For the buyer, the primary drawback is the high probability of the option expiring worthless. Since OTM options possess no intrinsic value, their worth is entirely dependent on the underlying asset's price moving favorably before the expiration date. If the anticipated price movement does not occur, the entire premium paid for the option is lost. This makes OTM options a highly speculative investment.
For sellers, while collecting premium from out of the money options can be an income-generating strategy, it comes with its own set of risks. Selling "naked" call option (without owning the underlying shares) exposes the seller to potentially unlimited losses if the underlying asset's price rises sharply. Regulatory bodies like FINRA have issued warnings regarding fraudulent activities involving options trading, highlighting the importance of understanding the inherent risk and the need for robust supervisory procedures by brokerage firms2, 3. The leverage offered by options can amplify both gains and losses, meaning that even small price movements against a seller's position can lead to substantial margin calls and potential forced liquidation of positions1.
Out of the Money vs. In the Money
The terms "out of the money" (OTM) and "in the money" (ITM) describe the immediate profitability of an options contract if it were to be exercised. The distinction lies in the relationship between the option's strike price and the current market price of the underlying asset.
| Feature | Out of the Money (OTM) | In the Money (ITM) |
|---|---|---|
| Call Option | Strike Price > Current Asset Price | Strike Price < Current Asset Price |
| Put Option | Strike Price < Current Asset Price | Strike Price > Current Asset Price |
| Intrinsic Value | Zero | Positive |
| Premium Source | Entirely time value | Intrinsic value + time value |
| Profitability | Not profitable if exercised immediately | Profitable if exercised immediately |
An option that is out of the money has no current profit potential from exercise, while an in the money option does. There is also an "at the money" (ATM) option, where the strike price is approximately equal to the current market price of the underlying asset.
FAQs
Q: Does an out of the money option have any value?
A: Yes, an out of the money (OTM) option can still have value, which is entirely its time value. While it has no intrinsic value, its time value reflects the possibility that the underlying asset's price could move in a favorable direction before the option's expiration date, making it profitable.
Q: Why would someone buy an out of the money option?
A: Investors typically buy out of the money options for their potential for high percentage returns if the underlying asset moves significantly in the anticipated direction. Since OTM options have lower premiums, a small investment can control a larger number of shares, offering considerable leverage. This strategy is often used for speculation on strong price movements.
Q: What happens if an out of the money option expires?
A: If an out of the money options contract reaches its expiration date and remains out of the money, it will expire worthless. This means both the buyer loses the entire premium paid, and the seller (writer) retains the full premium collected. Options are not automatically exercised if they are out of the money at expiration.