What Are Out of the Money Options?
Out of the money options refer to options contracts that currently hold no intrinsic value. In the realm of [options trading], a call option is considered out of the money (OTM) when its [strike price] is higher than the current market price of the [underlying asset]. Conversely, a put option is out of the money when its strike price is lower than the current market price of the underlying asset. These options are part of the broader category of [derivatives], financial instruments whose value is derived from an underlying asset. Because they have no intrinsic value, their entire premium consists of [extrinsic value], also known as [time value], which reflects the probability that the option will move into a profitable state before its [expiration date].
History and Origin
The concept of options has existed for centuries, with early forms of over-the-counter options being traded in the United States as far back as the late 18th century. However, the modern, standardized exchange-traded options market, which significantly impacted the prevalence and understanding of concepts like out of the money options, began with the establishment of the Chicago Board Options Exchange (CBOE). On April 26, 1973, the CBOE opened its doors, introducing the first standardized stock options contracts traded on a national securities exchange.4 This marked a pivotal shift from the opaque, bilaterally negotiated over-the-counter market to a more transparent system with defined terms and a central [clearinghouse]. This standardization, including set [strike price] and [expiration date] parameters, made it easier for traders to understand and assess the "moneyness" of an [options contract], including whether it was out of the money.
Key Takeaways
- Out of the money options lack intrinsic value, meaning they would not be profitable if exercised immediately.
- Their value is solely derived from their time value and the potential for the underlying asset's price to move favorably before expiration.
- Out of the money options generally have lower [options premium] compared to in-the-money or at-the-money options.
- They carry a higher probability of expiring worthless for the buyer, but offer high leverage potential if the underlying asset experiences a significant price movement.
- These options are frequently used in both speculative strategies and certain [hedging] tactics.
Interpreting Out of the Money Options
Interpreting an out of the money option involves understanding that its current value is purely speculative, based on the possibility of future price movements of the [underlying asset]. For a buyer of an out of the money [call options] or [put options], the position implies a belief that the underlying asset's price will move significantly enough for the option to become in the money before expiration. The further out of the money an option is, the less likely it is to finish in the money, but also the lower its initial cost. The price of an out of the money option is highly sensitive to [volatility] and the remaining time until its [expiration date], as these factors determine its extrinsic value. As time passes, the extrinsic value diminishes due to [time decay], making the option more susceptible to expiring worthless if the desired price movement does not occur.
Hypothetical Example
Consider an investor, Sarah, who believes that TechCorp stock, currently trading at $95 per share, will rise significantly in the next two months. She decides to purchase an out of the money [call options] contract on TechCorp with a strike price of $100, expiring in two months. Each options contract represents 100 shares. The [options premium] for this contract is $1.00 per share, meaning the total cost for one contract is $100 ($1.00 x 100 shares).
At the time of purchase, the option is out of the money because the strike price ($100) is higher than the current stock price ($95). Sarah is betting that TechCorp's price will exceed $100 before the expiration date, ideally moving high enough to cover the $1.00 premium and generate a profit.
If, at expiration, TechCorp's stock price is $105, Sarah's call option is now in the money. She has the right to buy TechCorp shares at $100, which she could then sell in the market for $105, realizing a $5 profit per share ($105 - $100 strike price). After accounting for her $1 premium paid, her net profit is $4 per share, or $400 per contract.
However, if TechCorp's stock price remains at $98 at expiration, the option is still out of the money. Since the stock price did not reach the $100 strike price, exercising the option would result in a loss. In this scenario, the option expires worthless, and Sarah loses the entire $100 premium she paid.
Practical Applications
Out of the money options serve various purposes in financial markets for both [speculation] and risk management. For speculative traders, buying out of the money options offers significant leverage. Because their premiums are relatively low, a small increase in the [underlying asset]'s price can lead to a large percentage gain on the option's value if it moves into the money. This makes them attractive for high-risk, high-reward strategies based on anticipated significant price swings.
Additionally, out of the money options are integral to many advanced [options trading] strategies, such as spreads. For instance, in a credit spread, an investor might sell an out of the money option and simultaneously buy another out of the money option with a different strike price to limit potential losses while earning a net premium. Investors often utilize short out of the money [put options] to generate income, particularly if they anticipate the underlying stock will not fall below a certain price, or if they are willing to acquire the stock at that lower price. This approach can be a form of yield enhancement or a way to enter a long position at a desired level. The U.S. Securities and Exchange Commission (SEC) provides introductory information on the basics and potential risks of options trading.3
Limitations and Criticisms
Despite their potential for high percentage gains, out of the money options come with significant limitations and risks. The primary criticism is their high probability of expiring worthless. Since they possess no [intrinsic value], their entire worth is tied to [time value], which erodes rapidly as the [expiration date] approaches. This phenomenon, known as [time decay], accelerates dramatically in the final weeks and days of an option's life, especially for out of the money contracts.2, If the [underlying asset] does not reach the [strike price] before expiration, the option buyer will lose the entire [options premium] paid.
Furthermore, the significant leverage offered by out of the money options can amplify losses. While a small premium can lead to large gains, it also means that the entire investment can be lost with little movement against the desired direction. For option sellers, writing uncovered out of the money options can expose them to potentially unlimited losses if the market moves sharply against their position, highlighting the importance of understanding margin requirements and risk. Opening an options account requires a thorough understanding of these risks, and broker-dealers typically assess an investor's knowledge and financial capacity before granting [options trading permissions].1
Out of the Money Options vs. In the Money Options
The distinction between out of the money (OTM) and [in the money options] (ITM) lies in their immediate profitability if exercised and the composition of their [options premium].
| Feature | Out of the Money (OTM) | In the Money (ITM) |
|---|---|---|
| Intrinsic Value | None | Positive |
| Premium Makeup | Purely [extrinsic value] (time value) | Intrinsic value + [time value] |
| Call Option | Strike price > Current underlying asset price | Strike price < Current underlying asset price |
| Put Option | Strike price < Current underlying asset price | Strike price > Current underlying asset price |
| Cost | Generally less expensive | Generally more expensive |
| Immediate Profit | No immediate profit if exercised | Immediate profit if exercised |
| Time Decay | More sensitive to time decay, especially nearing expiration | Less sensitive to time decay due to intrinsic value |
Confusion often arises because both types of options have extrinsic value, but only ITM options possess intrinsic value. OTM options are cheaper because their path to profitability requires a more significant move in the underlying asset, making them inherently riskier for buyers seeking exercise. ITM options, conversely, already have an embedded profit, making them less leveraged but also less prone to expiring worthless solely due to lack of movement.
FAQs
Can out of the money options be profitable?
Yes, out of the money options can become profitable if the [underlying asset]'s price moves favorably and crosses the [strike price] before or at the [expiration date], making the option "in the money." The profit would then be the difference between the final price and the strike price, minus the initial [options premium] paid.
Why are out of the money options cheaper?
Out of the money options are generally cheaper because they have no [intrinsic value]. Their entire premium is based on their [extrinsic value], which reflects the probability of the underlying asset moving past the [strike price] before the [expiration date]. Since this probability decreases the further out of the money an option is, its price will be lower.
Do out of the money options always expire worthless?
No, out of the money options do not always expire worthless. They only expire worthless if the [underlying asset]'s price does not move beyond the [strike price] by the [expiration date]. If the price moves favorably, the option can become "in the money" and retain value or be exercised for a profit. However, a significant percentage of purchased out of the money [options contract] do expire without value.
What is "moneyness" in options trading?
"Moneyness" describes the relationship between an option's [strike price] and the current market price of its [underlying asset]. An option can be either [in the money options] (ITM), [at the money options] (ATM), or out of the money (OTM), indicating its immediate profitability or lack thereof if exercised.