What Is Out of the Money Option?
An out of the money option (OTM) is an options trading contract that has no intrinsic value. This means that if the option were to expire immediately, it would be worthless. OTM options are a fundamental concept within the broader category of derivatives, specifically in the realm of options contracts. The value of an out-of-the-money option is composed entirely of its time value, reflecting the market's expectation that the underlying asset might move favorably before the expiration date.
For a call option, it is out of the money if the underlying asset's current market price is below the option's strike price. Conversely, for a put option, it is out of the money if the underlying asset's current market price is above the option's strike price. Traders often buy or sell out-of-the-money options for speculative purposes, betting on significant price movements in the underlying security.
History and Origin
The concept of options, including those that are out of the money, has roots dating back centuries, with early forms of options contracts observed in various markets. However, the modern, standardized exchange-traded options market, which clearly defines terms like "out of the money," began with the establishment of the Chicago Board Options Exchange (CBOE). The CBOE, now known as Cboe Global Markets, was founded in 1973 as the first U.S. exchange to list standardized options. Before this, options were primarily traded over-the-counter (OTC) with complex and non-uniform terms5. The standardization brought by the CBOE allowed for clear classification of options based on their relationship to the strike price, such as out-of-the-money, in-the-money, and at-the-money, making these concepts universally understood and tradable across wider markets.
Key Takeaways
- An out-of-the-money option has no intrinsic value and would expire worthless if exercised immediately.
- For a call option, it's OTM if the underlying price is below the strike price.
- For a put option, it's OTM if the underlying price is above the strike price.
- The entire value of an out-of-the-money option consists solely of its time value.
- OTM options are generally cheaper than in-the-money or at-the-money options due to their lower probability of expiring profitably.
Formula and Calculation
The intrinsic value of an out-of-the-money option is zero. Its entire option premium is composed of extrinsic value, primarily time value and implied volatility.
For a call option:
If ( \text{Underlying Price} < \text{Strike Price} ), then Intrinsic Value ( = 0 )
For a put option:
If ( \text{Underlying Price} > \text{Strike Price} ), then Intrinsic Value ( = 0 )
The market price (premium) of an out-of-the-money option at any given time can be expressed as:
Since intrinsic value is zero for an OTM option:
Thus, the premium of an out-of-the-money option is purely its extrinsic value, which decays as the expiration date approaches.
Interpreting the Out of the Money Option
When an option is out of the money, its status indicates that the market price of the underlying asset has not yet moved sufficiently to make the option profitable if exercised immediately. The premium paid for an out-of-the-money option primarily reflects the market's expectation of future volatility and the remaining time until expiration. A higher premium for a deeply out-of-the-money option might suggest that market participants anticipate a significant price movement in the underlying, reflecting higher implied volatility4. Investors interpret OTM options as a bet on directional price movement within a specific timeframe, acknowledging the increasing risk of the option expiring worthless as the expiration date nears.
Hypothetical Example
Consider a stock, XYZ, currently trading at $50 per share.
An investor is looking at XYZ call option contracts expiring in three months.
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XYZ Call Option with a $55 strike price: Since the current stock price ($50) is below the strike price ($55), this call option is out of the money. If the option had to be exercised today, the holder would buy shares at $55 that are only worth $50 in the market, resulting in a loss. Its value is entirely based on the possibility that XYZ's price will rise above $55 before expiration.
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XYZ Put Option with a $45 strike price: Since the current stock price ($50) is above the strike price ($45), this put option is also out of the money. If the option had to be exercised today, the holder would sell shares at $45 that are worth $50 in the market, again resulting in a loss. Its value stems from the chance that XYZ's price will fall below $45 before the expiration date.
In both cases, the out-of-the-money status means the option currently holds no intrinsic value.
Practical Applications
Out-of-the-money options are commonly used by investors for various strategic purposes within options trading. One primary application is pure speculation, where traders anticipate a large directional move in the underlying asset. For instance, a trader bullish on a stock might buy a far out-of-the-money call option because its option premium is significantly lower than that of an in-the-money option or at-the-money option, offering potentially high percentage returns if the underlying moves favorably.
Another practical application is in generating income through option selling strategies, such as selling covered calls or cash-secured puts. For example, an investor holding shares of a stock might sell out-of-the-money call options against their shares. If the stock price does not rise above the strike price, the options expire worthless, and the seller retains the premium as income. Conversely, selling out-of-the-money put options can be a way to acquire a stock at a lower price or to collect premium income if the stock remains above the put's strike. These strategies, while aiming for income, involve specific risk management considerations. The SEC Investor Bulletin provides further introductory information on basic options trading, including associated risks3.
Limitations and Criticisms
While out-of-the-money options offer potential for high percentage returns due to their lower upfront cost, they come with significant limitations and criticisms. The primary drawback is the high probability of expiration worthless, as the underlying asset must move substantially in the desired direction for the option to gain intrinsic value. This makes them inherently speculative and often leads to the loss of the entire option premium paid by the buyer.
Furthermore, OTM options are highly susceptible to time decay, also known as Theta, which erodes their value as they approach their expiration date. This decay accelerates closer to expiration, making it challenging for buyers to profit unless a significant and rapid price movement occurs. For sellers of out-of-the-money options, while they collect premium, they face potential unlimited losses if the underlying moves sharply against their position, particularly for uncovered options. Regulatory bodies like the Federal Reserve and the SEC continuously monitor the broader financial markets and associated risks, including those prevalent in derivatives trading1, 2.
Out of the Money Option vs. In-the-Money Option
The key distinction between an out of the money option (OTM) and an in-the-money option (ITM) lies in their intrinsic value and relationship to the strike price. An ITM option possesses intrinsic value, meaning it would be profitable if exercised immediately. For a call option, ITM occurs when the underlying asset's price is above the strike price. For a put option, ITM occurs when the underlying asset's price is below the strike price.
Conversely, an out-of-the-money option has no intrinsic value. Its entire premium is composed of time value, and it would be worthless if exercised immediately. This fundamental difference leads to ITM options generally having higher premiums than OTM options for the same expiration date and underlying asset, as ITM options offer immediate profit potential. OTM options are more speculative, while ITM options are often used for taking immediate exposure to the underlying asset or for hedging.
FAQs
What does it mean if an option is out of the money?
If an option is out of the money, it means that its strike price is unfavorable compared to the current market price of the underlying asset, rendering it worthless if exercised immediately. For a call, the strike is above the current price; for a put, the strike is below the current price.
Do out-of-the-money options have any value?
Yes, out-of-the-money options do have value, but it is solely time value (also known as extrinsic value). This value reflects the market's expectation that the underlying asset's price might move favorably before the option's expiration date, making the option profitable.
Why would someone buy an out-of-the-money option?
Investors often buy out-of-the-money options for their leverage and lower cost. If the underlying asset experiences a significant favorable price movement, an OTM option can become highly profitable very quickly, offering a high percentage return on the initial, smaller investment (the option premium).
What is the risk of buying an out-of-the-money option?
The primary risk of buying an out-of-the-money option is that it has a high probability of expiring worthless. If the underlying asset does not move beyond the strike price by the expiration date, the buyer loses the entire premium paid. This makes OTM options speculative investments.