Out of the money otm

What Is Out of the Money (OTM)?

An "out of the money" (OTM) options contract is a state where an option holds no intrinsic value if exercised immediately. This classification is a key concept in options trading, a segment of derivatives that derives its value from an underlying asset. An option is OTM when its strike price is unfavorable relative to the current market price of the underlying asset. For a call option, which grants the right to buy, it is OTM if the strike price is above the current market price. Conversely, for a put option, which grants the right to sell, it is OTM if the strike price is below the current market price. Out of the money options still carry time value, which is the portion of the option premium attributable to the remaining time until its expiration date and the underlying asset's volatility.

History and Origin

The modern era of standardized options trading began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. Prior to this, options were traded over-the-counter with inconsistent terms. The CBOE introduced standardized options contracts, which helped to formalize the market and make options trading more accessible. The exchange began trading on April 26, 1973, in what was formerly the Chicago Board of Trade's smoking lounge, and initially only offered call options.⁴ The standardization facilitated the development of sophisticated pricing models, notably the Black-Scholes model, published the same year. This marked a significant turning point, moving options from an obscure, often unregulated corner of finance into a legitimate and widely used financial instrument.

Key Takeaways

• Out of the money (OTM) describes an options contract that has no intrinsic value.
• For a call option, OTM means the strike price is higher than the underlying asset's current price.
• For a put option, OTM means the strike price is lower than the underlying asset's current price.
• OTM options' value is solely derived from their time value and implied volatility, meaning they consist entirely of extrinsic value.
• If an OTM option remains out of the money until its expiration date, it will expire worthless.

Formula and Calculation

The intrinsic value of an out of the money (OTM) option is zero. The total value of an option premium is composed of its intrinsic value and its time value. For an OTM option, the intrinsic value component is absent because exercising it immediately would result in a loss or no gain.

• For a Call Option (OTM):
  The current price of the underlying asset ((S)) is less than the strike price ((K)).
  Intrinsic Value = (\max(0, S - K))
  Since (S < K), then (S - K < 0), so Intrinsic Value = (0).

• For a Put Option (OTM):
  The current price of the underlying asset ((S)) is greater than the strike price ((K)).
  Intrinsic Value = (\max(0, K - S))
  Since (K < S), then (K - S < 0), so Intrinsic Value = (0).

Therefore, the entire premium of an out of the money option is composed of its time value. As the expiration date approaches, this time value erodes, a phenomenon known as theta decay.

Interpreting the Out of the Money (OTM)

Interpreting an out of the money (OTM) option involves understanding its potential and risks. An OTM option signifies that the market price of the underlying asset has not yet moved favorably enough for the option to be profitable upon immediate exercise. Because OTM options lack intrinsic value, their entire price, or option premium, is made up of extrinsic value, primarily time value and volatility.

For buyers, OTM options are generally cheaper than their in the money or at the money counterparts, offering a way to speculate on large price movements with a relatively smaller capital outlay. However, the probability of an OTM option expiring worthless increases as the expiration date approaches, unless the underlying asset's price moves significantly past the strike price. For sellers, writing OTM options can generate income from the premium collected, with the expectation that the option will expire worthless. However, sellers face unlimited potential losses if the underlying asset's price moves sharply and unexpectedly, pushing the option into the money.

Hypothetical Example

Consider an investor who believes the stock price of Company XYZ, currently trading at $100 per share, will rise significantly. They decide to buy an out of the money call option.

• Company XYZ Stock Price: $100
• Call Option Strike Price: $105
• Expiration Date: One month from now
• Option Premium (cost): $1.50 per share (or $150 for one standard 100-share options contract)

In this scenario, the call option is OTM because the strike price ($105) is higher than the current stock price ($100). If the investor were to exercise the option immediately, they would buy shares at $105 each when they could buy them in the open market for $100, resulting in a loss. The entire $1.50 premium paid is time value, reflecting the possibility that Company XYZ's stock price could exceed $105 before the expiration date.

If, by expiration, the stock price rises to $107, the option is now in the money by $2 ($107 - $105). The investor's profit would be $2 (intrinsic value) - $1.50 (premium paid) = $0.50 per share, or $50 per contract, excluding commissions. If the stock price remains at or below $105, the out of the money call option expires worthless, and the investor loses the entire $150 premium paid.

Practical Applications

Out of the money (OTM) options serve various purposes in options trading and risk management:

• Speculation: Traders often buy OTM options to speculate on significant price movements in the underlying asset. They are cheaper than in the money options, offering high leverage for a relatively small upfront cost. If the underlying asset moves sharply in the desired direction, the OTM option can become profitable quickly. However, the probability of profit for OTM options is generally lower than for at-the-money or in-the-money options.
• Income Generation: Investors sell OTM options (known as "writing" or "selling to open") to collect the option premium. This strategy banks on the OTM option expiring worthless, allowing the seller to keep the premium. This is common in covered call strategies where an investor sells OTM calls against shares they already own.
• Hedging (with limitations): While less common for direct hedging compared to at-the-money or in-the-money options, deep OTM put options can offer inexpensive, albeit limited, portfolio protection against extreme downside movements. However, investors largely avoided short-dated OTM options for protection during significant market downturns, opting instead for longer-dated contracts, as the rapid price changes can make OTM options difficult to price and utilize effectively for immediate risk management.³
• Spreading Strategies: OTM options are integral components of various multi-leg option strategies, such as vertical spreads (e.g., credit spreads, debit spreads), iron condors, and butterflies. These strategies combine multiple options contracts with different strike prices and/or expiration dates to define risk and reward profiles.

Limitations and Criticisms

While out of the money (OTM) options offer certain advantages, they also come with significant limitations and criticisms:

• Low Probability of Profit: The primary criticism of buying OTM options contracts is their inherently low probability of expiring profitably. For an OTM option to become profitable, the underlying asset must move sufficiently in the anticipated direction and surpass the strike price by an amount greater than the premium paid, all before the expiration date. Many OTM options expire worthless.
• Time Decay (Theta Decay): OTM options consist entirely of time value. This value erodes at an accelerating pace as the expiration date approaches, making it difficult for OTM options to retain their value unless there is a rapid, significant move in the underlying asset.
• Sensitivity to Volatility: While OTM options benefit from an increase in implied volatility, they are also highly sensitive to decreases in volatility. A drop in expected price swings can quickly diminish their value, even if the underlying asset's price doesn't move adversely.
• Liquidity Issues: Deep out of the money options, those with strike prices far from the current market price, may suffer from lower trading volume and wider bid-ask spreads, making it difficult to enter or exit positions efficiently.
• Complex Pricing Challenges: Accurately pricing options, especially OTM ones, relies on sophisticated models like the Black-Scholes formula.² However, these models operate on certain assumptions (e.g., constant volatility, no dividends) that may not hold true in real markets, leading to potential mispricing and unexpected outcomes. Academic research indicates that the Black-Scholes model, while widely used, may not always accurately price put options in all market conditions.¹ This complexity introduces additional risk management challenges for traders.

Out of the Money (OTM) vs. In the Money (ITM)

Out of the money (OTM) and in the money (ITM) represent opposite states for an options contract concerning its intrinsic value. An OTM option has no intrinsic value, meaning it would not be profitable to exercise it immediately. Its value is purely derived from time value and other extrinsic factors. In contrast, an ITM option possesses intrinsic value because its strike price is favorable relative to the underlying asset's current market price, allowing for immediate profitable exercise.

FAQs

What happens if an out of the money option expires?

If an options contract is out of the money at its expiration date, it expires worthless. This means the option holder loses the entire option premium they paid for the contract.

Can out of the money options become profitable?

Yes, an out of the money option can become profitable if the price of the underlying asset moves favorably past the strike price by an amount greater than the premium paid, before or at expiration. For a call option, the underlying asset's price must rise above the strike price. For a put option, the underlying asset's price must fall below the strike price.

Is it riskier to buy or sell out of the money options?

Both buying and selling out of the money (OTM) options involve risks, but the nature of the risk differs. Buying OTM options carries a risk limited to the premium paid, as the most you can lose is the cost of the option. Selling (or writing) OTM options can expose the seller to theoretically unlimited losses (for uncovered calls) or substantial losses (for uncovered puts), especially if the underlying asset makes a significant unexpected move that turns the OTM option into an in the money position. However, selling OTM options can generate income from the collected option premium.

What is the difference between out of the money, in the money, and at the money?

These terms describe the relationship between an option's strike price and the current market price of its underlying asset. An option is out of the money (OTM) if it has no intrinsic value (e.g., call strike > asset price). It's in the money (ITM) if it has intrinsic value (e.g., call strike < asset price). It's at the money (ATM) if the strike price is approximately equal to the current asset price.