Introduction to Out-of-the-Money Options

Introduction to Out-of-the-Money Options

You know, an 'out of the money' option has no intrinsic value.

As an investor, you use options to profit from price movements and protect against potential losses in your portfolios. But before you add this tool to your investing arsenal, you need to understand how these contracts work and the jargon involved.

One key term you'll encounter is 'moneyness.' Options are described as 'in the money,' 'out of the money,' or 'at the money' based on their intrinsic value at any moment. As the name suggests, 'out of the money,' which is what I'm covering here, refers to an option that can't be exercised for a profit right now.

Key Takeaways

Let me lay out the essentials for you. An out-of-the-money option can't be exercised for a profit currently, but it still holds value based on the time left before expiration and the chance of reaching the strike price.

The value of an OTM option hinges on how much time remains and the volatility of the underlying security.

Sure, OTM options carry a higher risk of expiring worthless, but they appeal to traders with less capital or those willing to bet on big price movements.

Understanding Options: Basic Concepts

Options give you the right, but not the obligation, to buy or sell a security like a stock, bond, or currency at a certain price, called the strike price, by a specified date known as the expiration date.

In every transaction, there are two sides betting against each other. There's the seller, who creates the option hoping it won't be exercised, in exchange for a fee called the premium. And there's the buyer, who pays for the option believing the strike price will be exceeded, making them money.

Remember, American-style options can be exercised any time before or on the expiration date, while European-style options can only be exercised on the exact expiration date.

When you buy an option, you're betting the price will rise above the strike price, which means buying a call option, or that it will fall below, which means buying a put option.

Example of Options

Take James, for instance. He thinks Company ABC’s share price will rise to at least $500. Instead of buying the stock, he purchases a call option for $200, giving him the right to buy 100 shares, currently trading at $400, for $430 within six months.

If Company ABC rises to $500 within six months, James could exercise the option, buy the stock for $430, and sell it for $500. That nets him $7,000 ($70 x 100 shares), minus the $200 premium and fees.

The same logic applies the other way. If James thought the price would fall, he'd buy a put option, paying a fee for the right to sell shares at a specified price within the time frame. For profit, the share price needs to drop below the strike price.

Defining 'Out of the Money' (OTM)

Whether you exercise an option depends mainly on the relationship between the market price of the security and the strike price.

Options can be in-the-money (ITM), where the strike price is favorable and you could profit by exercising; at-the-money (ATM), where the strike is equal or very near the current price, offering no immediate profit but potential with small moves; or out-of-the-money (OTM), where the strike isn't favorable and exercising would lose you money.

For example, an option to buy a stock at $120 when it trades at $100, or sell at $100 when it trades at $120, is OTM. It's basically the worst spot for an unexpired option holder, with no intrinsic value—exercising now means losing money.

That said, OTM options can still be worth something. They have extrinsic or time value. As long as there's a chance the stock rises above $120 or falls below $100 in my example, it has value. This depends on time left before expiration and the security's volatility. More swings and more time improve the odds.

Characteristics of OTM Options

OTM options have distinct traits. They're not worth exercising now because the strike price hasn't been reached, so you'd lose money.

Time is crucial. They aren't valueless; there's still a chance they move into profit before expiring. The farther the expiration, the better, giving more time to hit the target.

They're cheaper than ITM or ATM options with the same expiration because they can't be profitably exercised yet, and reaching the strike often needs a big price move. Time is their main advantage.

Example of OTM Options

Consider Matt, who's bullish on Company XYZ at $120 a share. He buys a call option with a $150 strike price, expiring in five months, costing $1 per share. For 100 shares, that's $100 plus fees.

To profit, he needs XYZ to trade at least $151 when he exercises. The higher, the better.

It doesn't go as planned. Shares bounce to $155, making it ITM, but Matt holds for more upside. Then economic data causes drops to between $100 and $115.

With one month left, Matt could sell the option, now worth less than $100 due to lower price and little time. Or hold and hope. He holds.

Two weeks later, shares hit $145. Doubting further rise, Matt sells the option for $0.90 per share, or $90, limiting his loss to $10 plus fees.

The Bottom Line

Out-of-the-money (OTM) options are contracts with no current intrinsic value since they can't be exercised for profit. But they hold value based on potential to become profitable before expiration if the market moves favorably.

Some investors prefer buying OTM options because they're cheaper and offer higher potential returns. However, they have a lower probability of profit and lose value as expiration approaches.