Out of the money",

What Is Out of the Money (OTM)?

"Out of the money" (OTM) describes an options contract that currently holds no intrinsic value. In the realm of derivatives, an option is OTM when its strike price is unfavorable compared to the current market price of the underlying asset. Specifically, for a call option, it is out of the money if the strike price is above the underlying asset's current market price. Conversely, for a put option, it is out of the money if the strike price is below the underlying asset's current market price. An out-of-the-money option only has extrinsic value, also known as time value, as its value is derived solely from the possibility of the underlying asset's price moving favorably before the option's expiration.

History and Origin

The concept of options trading, including the ideas of "in the money" and "out of the money," has roots in financial markets that predate modern exchanges. Early forms of options were traded bilaterally over-the-counter (OTC) with customized terms, making standardization and widespread adoption challenging. The formalization of options trading, and thus the clearer definition of strike price relationships, began in earnest with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. The CBOE was the first exchange to list standardized, exchange-traded stock options, introducing uniform contract sizes, strike prices, and expiration dates.⁸, ⁹ This standardization, alongside the creation of the Options Clearing Corporation (OCC) to ensure contract fulfillment, provided the framework necessary for options to become a widely traded financial instrument.⁷ The Securities and Exchange Commission (SEC) also played a role in regulating the U.S. securities options business, requiring the distribution of documents like "Characteristics and Risks of Standardized Options" to explain features and risks, including the concepts of in-the-money and out-of-the-money options.⁴, ⁵, ⁶

Key Takeaways

• An out-of-the-money (OTM) option has no intrinsic value, only extrinsic value.
• For a call option, it is OTM if the strike price is higher than the underlying asset's market price.
• For a put option, it is OTM if the strike price is lower than the underlying asset's market price.
• OTM options are generally cheaper than in-the-money options and at-the-money options.
• The likelihood of an OTM option becoming profitable depends on the underlying asset's price movement and the time remaining until expiration.

Formula and Calculation

While there isn't a direct "formula" to calculate whether an option is out of the money, its status is determined by a simple comparison between the underlying asset's current market price and the option's strike price.

For a Call Option:
An option is Out of the Money (OTM) if:
[ \text{Strike Price} > \text{Current Market Price of Underlying Asset} ]

For a Put Option:
An option is Out of the Money (OTM) if:
[ \text{Strike Price} < \text{Current Market Price of Underlying Asset} ]

The value of an out-of-the-money option is entirely derived from its extrinsic value, which can be influenced by factors such as time decay and volatility.

Interpreting the Out of the Money (OTM) Status

Understanding the "out of the money" status of an option is crucial for traders. An OTM option signifies that exercising it immediately would result in a loss or yield no profit, as the underlying asset's price has not moved favorably past the strike price. Its value is purely speculative, based on the expectation that the underlying asset's price will move sufficiently before the option's maturity date for the option to become profitable.

For example, an investor holding an OTM call option hopes the underlying stock price will rise above the strike price before expiration. Conversely, an investor with an OTM put option anticipates the underlying stock price will fall below the strike price. The further an option is out of the money, the lower its premium, reflecting the decreased probability of it becoming profitable. However, these options can also offer higher leverage due to their lower cost.

Hypothetical Example

Consider an investor, Sarah, who believes that Company XYZ's stock, currently trading at $50 per share, will increase in value. She decides to buy a call option on XYZ with a strike price of $55, expiring in three months. The premium she pays for this call option is $1.00 per share.

In this scenario, the call option is "out of the money" because the strike price ($55) is higher than the current market price of the underlying stock ($50). If Sarah were to exercise the option immediately, she would be able to buy shares at $55 each, which is more expensive than buying them directly in the market at $50. Therefore, the option has no intrinsic value. Its entire value is extrinsic, based on the hope that XYZ's stock price will rise above $55 before the option expires. If, for instance, XYZ's stock price rises to $60 before expiration, the option would then be "in the money" by $5.00 per share ($60 - $55).

Conversely, imagine another investor, John, who believes XYZ's stock will fall. He buys a put option on XYZ with a strike price of $45, when the stock is still trading at $50. This put option is "out of the money" because the strike price ($45) is lower than the current market price ($50). John would only profit if the stock price falls below $45 before the option expires.

Practical Applications

Out-of-the-money options are frequently used in various trading strategies for different purposes:

• Speculation: Traders might buy OTM options for speculative purposes due to their lower cost and higher leverage potential. If the underlying asset moves significantly in the anticipated direction, these options can yield substantial percentage returns. This is often seen in strategies like directional trading.
• Hedging: While less common than using in-the-money or at-the-money options, OTM options can be part of a hedging strategy to protect against extreme price movements. For example, a portfolio manager might buy far OTM put options as cheap "disaster insurance" against a severe market downturn.
• Income Generation (Selling OTM Options): Investors sometimes sell (write) OTM options to collect the premium. This strategy, known as selling covered calls or naked puts, is often employed when the seller believes the underlying asset's price will not reach the strike price by expiration, allowing them to keep the premium as profit. However, this strategy carries significant risk.
• Structured Products: OTM options are components in many complex structured products and derivatives strategies, where their specific risk-reward profiles contribute to the overall payout structure.

The use of derivatives, including out-of-the-money options, can introduce various risks such as market, counterparty default, and illiquidity risk. As Federal Reserve Chair Jerome Powell has noted, derivatives transactions involve numerous risks, and investors should seek expert legal and financial advice before engaging in such transactions.³

Limitations and Criticisms

While out-of-the-money options offer potential benefits, they also come with significant limitations and criticisms:

• High Probability of Expiration Worthless: The most significant drawback of OTM options is their high probability of expiring worthless. If the underlying asset's price does not move favorably beyond the strike price before expiration, the option holder loses the entire premium paid.
• Sensitivity to Time Decay: OTM options are highly susceptible to time decay (theta). As an option approaches its expiration date, its extrinsic value erodes at an accelerating rate, making it increasingly difficult for OTM options to become profitable.
• Lower Delta: The delta of an OTM option is relatively low, meaning its price changes less in response to movements in the underlying asset's price compared to at-the-money or in-the-money options. This can make it challenging for OTM options to gain significant value unless there's a substantial price swing in the underlying.
• Liquidity Concerns: Far out-of-the-money options may have lower trading volume and wider bid-ask spreads, making it harder to enter or exit positions at favorable prices.
• Misconceptions of "Cheapness": While OTM options have lower premiums, this can sometimes lead investors to perceive them as "cheap" without fully appreciating the low probability of profit. This can encourage excessive risk-taking.
• Complex Pricing: The Black-Scholes model, a widely used option pricing model, values options based on several inputs, including volatility and time to expiration.² However, this model, while foundational, makes assumptions (e.g., constant volatility, no dividends, European-style exercise only) that may not always hold true in real-world markets, particularly for American options, which can be exercised before expiration.¹

Out of the Money vs. In the Money

The primary distinction between "out of the money" (OTM) and "in the money" (ITM) options lies in their intrinsic value.

Confusion often arises because both OTM and ITM options are part of the broader options market, but they represent opposite sides of the profitability spectrum relative to the current market price. OTM options are often seen as riskier or more speculative due to their inherent lack of immediate profit, while ITM options are generally considered safer as they already possess some tangible value.

FAQs

What does "out of the money" mean for a call option?

For a call option, "out of the money" means that the strike price is higher than the current market price of the underlying asset. For example, if a stock is trading at $100 and you have a call option with a strike price of $105, that call option is out of the money. You would not make money by exercising it immediately.

What does "out of the money" mean for a put option?

For a put option, "out of the money" means that the strike price is lower than the current market price of the underlying asset. For instance, if a stock is trading at $100 and you hold a put option with a strike price of $95, that put option is out of the money. Exercising it instantly would result in a loss.

Can an out-of-the-money option become profitable?

Yes, an out-of-the-money option can become profitable if the price of the underlying asset moves sufficiently in the desired direction before the option's expiration date. For a call, the price must rise above the strike price (plus premium paid), and for a put, the price must fall below the strike price (minus premium paid). This transition is when an option goes from being out of the money to in the money.

Why would someone buy an out-of-the-money option?

Traders often buy out-of-the-money options for their relatively low cost and high leverage potential. If a significant price move is anticipated, an OTM option can offer substantial percentage returns compared to buying the underlying asset directly or an in-the-money option. However, this comes with a higher risk of losing the entire investment.

What is the value of an out-of-the-money option?

An out-of-the-money option has no intrinsic value. Its entire value is based on its extrinsic value, also known as time value. This extrinsic value is influenced by factors such as the time remaining until expiration, the volatility of the underlying asset, and interest rates. As expiration approaches, this extrinsic value erodes, a phenomenon known as theta decay.