Understanding Out of the Money (OTM) Options: What Investors Need to Know
Out of the Money (OTM) describes an option contract that only possesses extrinsic value—such options feature a delta of less than 0.50.
An OTM call option has a [strike price] higher than the market price of the underlying asset, while an OTM put option features a strike price lower than the market price of the underlying asset.
OTM options contrast with In the Money (ITM) options.
Key Takeaways
- OTM explained: OTM means an option has no intrinsic value, only extrinsic value.
- Understanding calls and puts: A call is OTM if the underlying price is below the strike price; a put is OTM if the underlying price is above the strike price.
- Comparative value: OTM options cost less than ITM or ATM options due to lacking intrinsic value.
Basics of Options
For a premium, stock options grant the right, but not the obligation, to buy or sell an underlying asset at an agreed-on price before a specified expiration date.
- Call options: These allow buying an underlying asset when anticipating a price rise.
- Put options: These allow selling an underlying asset when expecting a price drop.
Options derive their value from an underlying security and can be OTM (out of the money), ITM (in the money), or ATM (at the money).
Identifying OTM Options
An option is OTM if:
- For a call option, the underlying price is below the strike price.
- For a put option, the underlying price is above the strike price.
OTM options have only extrinsic or time value.
A trader can still profit from an OTM option before it expires by selling it for more than the purchase price.
Consider a stock at $10:
- Call options above $10: OTM calls
- Put options below $10: OTM puts
Typically, OTM options aren’t worth exercising. Exercising in the current market offers a more favorable trade level than the option’s strike price.
Contrasting OTM and ITM Options
- ITM: Current market price > strike price for calls or < strike price for puts.
- OTM: Current market price < strike price for calls or > strike price for puts.
Options that are ITM demand higher premiums due to favorable exercise conditions.
Moneyness and Option Delta
Delta measures risk—indicative of the price change of the option given a $1 movement in the underlying security.
- OTM options: Have a delta < 0.50.
- ITM options: Have a delta > 0.50.
- ATM options: Delta close to 0.50.
Real-World Example
A trader purchases a call option on Vodafone with a $20 strike price, expiring in five months, costing $0.50. The stock trades at $18.50.
- Exercise now?: No, exercise price is higher than market price.
- Profit potential?: Yes, if the stock rises above $20 before expiration or if the sold premium increases before the stock hits $20, allowing a profitable sale of the option.
If the stock moves to $22:
- Profit from transaction: Initial investment - final value difference.
OTM at Expiration
OTM options expire worthless. Value before expiration is tied to the time value.
Final Thoughts
Out of the Money (OTM) reflects options without intrinsic value but holding extrinsic value. Calls are OTM with a strike price above market price; puts are OTM with a strike price below market price. Contrast OTM with ITM or ATM options.
Related Terms: In the Money, At the Money, Intrinsic Value, Extrinsic Value.
