Out of the Money

Out of the Money (OTM) Option Meaning

Out of the money options, strike prices (OTM) are strikes that trade above or below the stock’s current price. These strikes are the cheapest because they trade below the stock price 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 the probability of OTM to your brokerage platform to see your probability of success in the trade. 

Out of the money (OTM) options, contracts for calls have a higher strike price than the market price. Out of the money options, contracts for puts have a lower strike price than the market price. One of the three “money” components of options trading is OTM.

There are three types of moneyness in options trading: in, at, and out of the money. Each type affects how stocks profit and how much you’ll pay 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 composed of extrinsic value, also known as time value.

Options expire. Hence, it is important to choose 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 to. 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 OTM at the expiration, it expires worthless. In other words, you don’t make a profit. The goal is to have the contract close in the money.

Breakdown

Let’s say we’re looking at a stock currently trading at $30. Out of the money calls would have a strike 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 will reach $35 by a certain time. At this point, the market price is less than the out of the money strike price. As a result, it’s not worth exercising at this point.

However, if you buy the $35 strike price and the stock moves up to $40, your option moves into the money. Paper trading options make the process easier the more that you practice.

Having intrinsic value isn’t always a profitable option. 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 $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, 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 exceeds $30. More often than not, if the 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.

Out of the Money Example

Out of the Money Example

This is an example of $SPY on an options chain. The highlighted area is the OTM strike prices. The gray-shaded areas are the ITM strikes. ATM is the strike closest to the current price of the $SPY, which is $393. This example shows $SPY trading at $393.03, so any strikes above that price are OTM. Any strikes below would be in the money. You can see how these orders play out on options charts.

The options chain is also customizable. You can add columns such as intrinsic value, extrinsic value, implied volatility, and open interest. Options Greeks such as delta, gamma, theta, and vega are also important to add.

Buying a Put Option Out of the Money

Buying a put option that is out of the money can serve several purposes for traders and investors. Here are a few reasons why people might choose to buy out of the money put options:

1. Hedging

Investors may buy OTM put options to hedge against potential downside risk in their portfolio. By buying put options, an investor has the right, but not the obligation, to sell an asset at a predetermined price, known as the strike price, within a specific time period. This can protect their portfolio from potential losses if the market or the specific asset decreases in value.

2. Speculation

Some investors may purchase OTM put options as a speculative strategy. They anticipate a significant downward movement in the price of the underlying asset and hope to benefit from that decline. If their prediction comes true, the value of the put option may increase, leading to potential profits.

3. Cost Efficiency

Out-of-the-money put options are generally cheaper in terms of their premium than in-the-money or at-the-money options. This lower cost exposes traders to an asset’s downside potential while limiting their upfront investment.

It is important to note that buying out-of-the-money put options carries certain risks. If the underlying asset’s price remains above the strike price or does not significantly drop, the option may expire worthless, losing the premium you paid for the option.

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OTM Put Option to Hedge Risk

Let’s say an investor owns 500 shares of Company XYZ, currently trading at $75 per share. The investor believes a potential market downturn could negatively impact the stock price of Company XYZ.

To hedge against this downside risk, the investor buys out-of-the-money put options. They purchase five put option contracts, each representing 100 shares, with a strike price of $70 and an expiration date of one month. The premium for each put option contract is $2.

By buying these out of the money put options, the investor has the right, but not the obligation, to sell 500 shares of Company XYZ at the strike price of $70 per share at any time before the expiration date.

Let’s assume that the stock price of Company XYZ drops significantly over the next few weeks due to market volatility and economic factors. Eventually, the stock price reaches $60 per share.

At this point, the investor can exercise their put options. With each contract representing 100 shares, they can sell 500 shares of Company XYZ at $70 per share, even though the market price is only $60.

By exercising the put options, the investor receives $35,000 ($70 per share x 500 shares) while limiting their potential loss. Without the put options, the investor would have faced a loss of $7,500 (($75 market price – $70 strike price) x 500 shares).

The out of the money put options helped the investor hedge their risk by allowing them to protect the value of their shares if the stock price declined. While they paid a premium for the put options, the cost was lower than potential losses if the stock price had dropped significantly without any protection.

Key Takeaways

  • OTM option contracts have strike prices higher (for call options) or lower (for put options) than what the market charges for the underlying asset
  • OTM call options perform better when the underlying stock’s price spikes
  • Investors buy OTM put options to hedge against potential downside risk in their portfolios.
  • Out-of-the-money put options are generally cheaper.

Final Thoughts: Out of the Money Options (OTM)

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.

Frequently Asked Questions

Out of the money options contracts don't have intrinsic value. This means that they are less expensive but also less likely to expire in the money.

Deeply out of the money means that the strike price is a lot higher above (call side) or below (put side) of the current price of the stock. These are the cheapest options to purchase.

In the money options have a better probability of success than out of the money option. ITM options are also more expensive than OTM.

Out-of-the-money options perform better when the underlying stock's price spikes. Alternatively, buying ATM or ITM options may be better if you think there might be a smaller stock price increase.

Out-of-the-money options refer to option contracts where the strike price is higher (for call options) or lower (for put options) than what the market charges for the underlying asset. These options have no intrinsic value, meaning that if somebody exercised them, they would not result in a profit at the current market price.

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