The term out-of-the-money (OTM) refers to an option contract that is composed entirely of extrinsic value, or time value. This value is based on a variety of factors, including the time remaining until expiration, the expected volatility of the underlying asset, and even current interest rates.
Whether the option is out-of-the-money or in-the-money will really depend on whether we’re talking about a call or put option.
- Call options are considered “out-of-the-money” when the underlying stocks price is below the strike price.
- Put options are considered “out-of-the-money” when the underlying stocks price is above the strike price.
But what does that really mean?
Example of an Out-of-the-Money Call?
Pretend for a second you held a long call option on XYZ stock.
XYZ is currently trading for $100 a share and you own a long call with a strike price of $110.
With XYZ trading at $100, all of the strikes above 100 are considered out-of-the-money (OTM) since they’re composed entirely of extrinsic value. That also means if you decide to hold the option through expiration and the stock stays below $110, you would take a complete loss on the trade.
Example of an Out-of-the-Money Put?
Using that same example, but instead, let’s assume you decided to purchase a put option with a strike price of 90. We’ll also say you bought the put for $2 ($200).
With XYZ stock still trading at $100 a share, the 90 put you purchased is currently $10 out-of-the-money. If XYZ stays at that value through expiration this put would expire completely worthless and you would’ve lost $200 (premium paid).
If we instead pretend the stock moved down to $85, the amount made on the trade would be the in-the-money amount minus the premium paid. In this example, you would have made a total profit of $300 ($500 – $200).
Pros and Cons
Like all investments, trading out-of-the-money (OTM) options come with their own pros and cons. A few of those advantage include lower premiums, greater leverage, and reduced risk.
However, they’re also far more sensitive to time decay, lower liquidity, and have a higher probability of expiring worthless. Ultimately, you’ll want to have a solid understanding of how these options move and things to consider before entering the trade.
Keep reading to learn more…
Pros of OTM options
The most appealing aspect of out-of-the-money options is their low cost and increased leverage. This gives you control over significantly more shares with the same amount of capital needed for in-the-money options.
- Lower Premiums: OTM options will typically have lower premiums than ITM or ATM options. That’s because OTM options have a lower probability of expiring in the money, so they’re less desirable to traders and therefore trade at a cheaper price.
- Greater Leverage: OTM options can also provide far greater leverage than their ITM counterparts. This means that you can control a larger number of shares for a given amount of capital. If you believed a stock is going to make a big move, OTM options could get you greater profits with less capital at risk.
- Limited Risk: This goes hand in hand with the lower premiums paid. If purchasing an OTM option, the risk is limited to the cost of the trade.
Cons of OTM options
We’ve gone over all the positives, but what about the negatives?
All of that additional leverage comes with a cost. The largest of which being the effect of time decay over the life of the trade. Unlike in-the-money (ITM) options, OTM options are composed entirely of extrinsic value.
Because of that, if the option were to remain OTM through expiration, the entire value of the contract would have decayed to nothing. Leaving you with a complete loss on the position. A few other considerations can be found below.
- Reduced liquidity: OTM options tend to be less liquid. This means it could be difficult to exit the option when the time comes. Additionally, the bid/ask spread (the difference between the price at which you can buy and sell an option) is usually wider apart, so you may end up paying more to enter or exit the position.
- Time decay: OTM options are far more effected by time decay than ITM options. Time decay being the erosion of an option’s value as it approaches expiration. Out-of-the-money options are particularly susceptible to time decay since they are composed entirely
- Lower probabilities: Out-of-the-money options have a lower probability of expiring in-the-money, meaning as an option buyer, you have a greater chance of that option expiring worthless.
What is an options strike price?
The options strike price, also known as the exercise price, is the price at which the underlying stock can be bought or sold if the option is exercised.
A call option would grant the holder of the option the right to buy the underlying stock at the price. Whereas, the owner of a put option has the right to sell the underlying stock at the strike price.
Just keep in mind that the strike price is determined at the time you open the trade. There are a few instances where the strike could through no action on your part, although that is incredibly rare. The only time you’ll see that happen is in the event of some sort of corporate action, split, or merger of some kind.
How are options priced?
Options are complex, but their pricing follows a simple formula. The are just two parts to account for: intrinsic value and extrinsic value.
Intrinsic value is the amount an option would be worth if you were to exercise the contract immediately – commonly referred to as the “in-the-money” amount. Using an example, a $10 strike call on a stock trading for $12 a share would have an intrinsic value of $2.
Extrinsic value will take into account the time left till expiration, the volatility expected in the market, and even interest rates. It encompasses all the value left in the contract beyond the intrinsic value.
Recap
Out-of-the-money options are simply those contracts composed entirely of extrinsic value. Because of that, they have a greater chance of expiring worthless than those options in-the-money and are highly sensitive to time decay.
That risk does come with far more leverage meaning they could provide a far greater return in the event the stock does move in your favor. Like anything, they have their own pros and cons and you’ll need to keep that in mind before entering a new position.
But that’s all for now, happy trading everyone!
