What Is OTM ? 

Out-of-the-money (OTM) option is one of three terms used to describe an option’s ‘moneyness,’ the other two being at-the-money and in-the-money. An out-of-the-money options contract has not yet achieved the value of its strike price, thus possessing no intrinsic value and ultimately expiring worthless. 

OTM Explained, Understanding deep out of the money   

Let’s explore two examples of out-of-the-money options:  

an out-of-the-money call option and an out-of-the-money put option.  

– A call option is purchased when the underlying asset’s price is expected to rise. 

– A put option is purchased when the underlying asset’s price is expected to fall. 

• With a call option has been purchased  

The underlying market price must rise above the call option’s strike price to make a profit. This allows you to exercise the right to buy the underlying asset at the strike price and then sell it in the market at a higher price, generating an immediate profit. A call option remains out-of-the-money as long as the underlying asset trades below the call option contract’s strike price. 

• With a put option has been purchased 

The underlying market price must fall below the put option’s strike price to make a profit. This allows you to exercise the right to sell the underlying asset at the strike price, benefiting from the initial prediction of a price decline. A put option remains out-of-the-money as long as the underlying market trades above the put option contract’s strike price. 

Why use OTM Options? 

In fact, an out-of-the-money option will result in a loss of the premium paid for its purchase it, and a financial loss is always undesirable. However, such a loss is preferable to a loss in the value of the underlying asset. Therefore, investors often use options as a hedging mechanism against unfavorable movements in their current investment portfolios. 

In the Money vs. Out of the Money 

Traders classify options as “in-the-money” (ITM) or “out-of-the-money” (OTM) based on the relationship between the strike price and the market value of the underlying stock, a concept known as “moneyness”. 

An ITM option has a strike price that has exceeded the current stock price. Conversely, an OTM option has a strike price that the underlying stock has not yet reached, causing the option possessing no intrinsic value. 

In the Money  

In-the-money options (ITMs) have different purposes. For example, a trader may seek to hedge or partially hedge their position. They may also choose to purchase an option with intrinsic value, rather than just time value. 

Due to their intrinsic value, In-the-money options typically command higher prices than out-of-money (OTM) options within the same option chain, resulting in relatively smaller percentage price movements. Although in-money options can experience significant price fluctuations, their relative volatility is generally less pronounced than that of out-of-money options. 

Calls 

A call option gives its buyer the right, but not the obligation, to buy the stock at the strike price, exercised when and if it proves advantageous. Therefore, an “in-the-money” (ITM) call option has a strike price lower than the current stock price.   

For example, a call option with a strike price of $132.50 is considered an “in-the-money” (ITM) call option if the underlying stock is valued at $135 per share, since the strike price has been exceeded. Conversely, a call option with a strike price above $135 is considered an “out-of-the-money” (OTM) call option, since the stock has not yet reached that level. 

In the example above, the intrinsic value of the option is $2.50, but its purchase price could be $5. This $5 cost includes the intrinsic value of $2.50 and the remaining portion, known as the premium, which represents time value. The cost of time value increases as the option’s expiration date extends, reflecting the increased likelihood of volatility in the underlying stock price before expiration. This increased probability presents an opportunity for the option buyer, a corresponding risk for the option writer, and a claim for compensation. 

Puts  

Traders who expect a stock price to decline buy put options. Therefore, “in-the-money” (ITM) put options are those whose strike price exceeds the current stock price. 

For example, a put option with a $75 strike price is considered in the money if the underlying stock is valued at $72, because the stock price has already fallen below the strike price. Conversely, the same put option is considered out-of-money if the underlying stock is trading at $80. 

Typically, the price of a put option rises as the time to expiration increases, due to its inherent time value. 

Out of the Money  

Both in-the-money (ITM) and out-of-the-money (OTM) options have distinct advantages and disadvantages. Neither is inherently superior, rather, the various strike prices available within the options chain cater to a wide range of trader profiles and option strategies. 

The decision to purchase ITM or OTM options depends on your forecast for the underlying stock, your financial capabilities, and your specific investment goals. 

OTM options are generally more affordable than ITM options, making them an attractive option for traders with limited capital. 

OTM options are frequently used by those who anticipate significant price movements in the underlying stock. Due to the lack of intrinsic value, OTM options offer a lower initial cost compared to ITM options. For example, if a stock is currently priced at $100, you might purchase an over-the-money (OTM) call option with a strike price of $102.50, believing the stock has the potential to significantly exceed $102.50. 

Out-the-money (OTM) options often have higher relative gains and losses than (ITM) options. Because of their lower price, even small price fluctuations can generate significant percentage returns and increased volatility. 

It is not uncommon for the price of an OTM call option to rise from $0.10 to $0.15 in a single trading day, representing a 50% price change. 

In conclusion, out-the-money (OTM) options provide traders with a versatile tool to capitalize on anticipated price movements and hedge against potential losses. Whether you’re seeking to leverage capital, speculate on volatile stocks, or protect your portfolio, OTM options offer a wide range of possibilities. By understanding their characteristics and strategically incorporating them into your trading plan, you can enhance your ability to navigate the complexities of the options market. 

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