Out of the money options strike prices (OTM) are strikes that trade above or below the current price of the stock. These strikes are the cheapest because they trade below the price of the stock on the put side. They trade above the price of the stock on the call side. The deeper out of the money you go the cheaper the options contract will be because you have less of a chance of having a winning trade. Add Probability of OTM to your brokerage platform to see your probability of success on the trade.
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What Does Out of the Money (OTM) Mean?
Out of the money (OTM) options contracts for calls have a strike price that’s higher than the market price. Whereas out of the money options contracts for puts have a strike price that’s lower than the market price. Out of the money is one of the three “money” components to options trading.
There are three types of moneyness in options trading; in, at, and out of the money. Each type affects how stocks profit as well as how much you’ll be paying for the strike price.
A strike price is made up of both intrinsic and extrinsic value. Out of the money options don’t have any intrinsic value. However, they’re made up of extrinsic value, also known as time value.
Options expire. Hence the importance of choosing an expiration date. While an options contract with an expiration date of a few days to a week is cheaper, the more time you have the better.
It helps if the stock doesn’t head in the direction you need it do. It also helps with profit potential. The premium of an out of the money option erodes pretty fast the closer the expiration date approaches.
If the contract is still out of the money at the time of expiration, it expires worthless. In other words, you don’t make a profit. The goal is the have the contract close in the money.
Examples
Let’s say we’re looking at a stock that’s currently trading at $30. Out of the money calls would have a strike that’s higher than the current market price. Let’s say the strike price we’re looking at is $35.
In essence, we believe that the stock is going to reach $35 by a certain time. At this point in time, the market price is less than the out of the money strike price. As a result, it’s not really worth exercising at this point in time.
However, if you do buy the $35 strike price and the stock moves up to $40 then you’re option move move into the money. Paper trading options makes the process easier the more that you practice.
Having intrinsic value doesn’t always been an option will be profitable. It all depends on what you paid for the option and how much it’s moved.
For example, you bought the $35 strike and paid $2 for it. It went up to $36. In essence, you’d still be losing a $1 per share on the trade because you need it to go over $2 to turn a profit.
Trading Out of the Money
Support and resistance is one of the most important trading strategies you can learn. If you’re buying out of the money options then you’re banking on the stock moving upwards.
In that case, you need to know where resistance is. If resistance is at $30 where the stock is currently trading and you buy a $35 option, there’s a big chance the trade will go against you.
You may get lucky and have a breakout where the stock goes past $30. More often than not, if price can’t break that resistance level it’s falling back down to support.
However, if you buy an out of the money options contract at support, you have a much better chance of having it go into the money.
The Bottom Line
An out of the money option (short for OTM) has a strike price that’s higher than the market price for a call and lower than the market price for a put. Usually the goal for out of the money options contracts is to close in the money for a profit.
If you need more help, take our options trading course.
