What is OTM?
An “Out of the Money” (OTM) option is one that has no intrinsic value. That means if it is exercised by the holder, they would receive nothing. If it is a call option it is considered out of the money if the price of the underlying asset is below the strike price of the option. And if it is a put option it is considered out of the money if the price of the underlying asset is higher than the strike price of the option.
Explanation of Out of the Money
Let’s say you are going to purchase a call option with a strike price of $102 for a stock that is currently trading at $100. If the stock remains below your $102 strike price until the expiration of the option then the option will expire out of the money. It means the option expires worthless and the buyer loses whatever they paid to purchase the option. The same can happen for a put option. If the stock is trading at $100 and you purchase a put option with a strike price of $97 you would lose your investment if the price of the stock is above $97 at the expiration of the contract because the option would expire out of the money and be worthless.
Why Does it Matter if an Option is OTM?
Well, having an out of the money option means you’ll lose the premium paid to buy the option, and losing money is never a good thing. However, it is better than if you lost the value of the underlying asset. That’s why options are often used by investors to hedge against adverse moves in existing investments.
Moneyness in Options
Moneyness is a term used to describe the three states of intrinsic value in options. The moneyness of an option is determined by the underlying price of the asset and the strike price of the option. This relationship has a different effect on moneyness for puts and calls. There are three states of moneyness for options:
Out of the Money Options
A call option is considered to be out of the money whenever the strike price is above the market price of the underlying asset. An out of the money call has no intrinsic value and exercising such an option is a waste of the trader’s time since the call represents the right to buy the underlying asset at the strike price, but for an OTM call that’s more expensive than simply purchasing the asset at the current market price. A put option is the opposite from a call option. In the case of a put it is out of the money when the strike price of the option is below the market price of the underlying asset. If the strike price were above the market price the put option would be in the money. Again, exercising a put that is out of the money makes no sense because it has no intrinsic value, and you would be selling the underlying asset for less than you could on the open market.
Differences in Strike and Underlying Price for OTM Options
The difference between the strike price of the option and the current market price of the underlying asset does matter. If you have an option where the strike price is close to the market price of the underlying asset it is more valuable than when price is further away because it would take just a small move in the price for the option to move into the money. However, if the difference is quite large then the chance of the option moving into the money is very slight, giving the option a much smaller premium and different characteristics. This moneyness of options doesn’t only need to be considered in terms of ATM, ITM, and OTM. Instead it should be thought of as a scale, with options that are further from the mid-point of ATM having different characteristics.
Far OTM Options
When there is a large difference between the strike price and the price of the underlying asset the option is considered as a “Far OTM option”. In general, the characteristics of OTM options apply more as the current market price of the underlying asset moves further away from the strike price of the option.
OTM Option Characteristics
Because they have relatively low premiums and add leverage to a trade an OTM option is often attractive to hedgers and speculators alike. You’ll typically find that the OTM option is cheaper than ITM options because you aren’t paying for any intrinsic value. An OTM option consists entirely of time value. Because of this the rate of time decay in OTM options is often very rapid and costly, especially when considered on a percentage basis. This is true even when the option is very far from its expiration. Because OTM options have such low premiums they can also provide the trader with a significant amount of leverage because you can control large positions for a small premium. However, it is also true that an OTM option is less sensitive to price moves than the ITM or ATM option. The further out of the money an option becomes the less sensitive it is to price moves in the underlying asset. On the other hand, an OTM option can be extremely sensitive to market volatility. This is because the OTM option’s entire value consists of time value. This means OTM options are often used by speculators in volatility-based trades.
ADVANTAGES OF TRADING OTM OPTIONS
- Out of the money options typically have the largest percentage gain when the price of the underlying asset moves, which makes them more attractive to speculators than ATM or ITM options.
- Out of the money options have the cheaper premiums when compared with ATM and ITM options.
DISADVANTAGES OF OTM OPTIONS
- When the OTM option expires worthless you lose all your premium.
- There’s a greater chance that you’ll suffer a loss with OTM options because the price of the underlying stock needs to move significantly to bring the option into the money and make it profitable.