How Out of the Money Options Work
Watch our video on how out of the money options contracts work when trading options. This is a critical component of trading, and the worst and most risky of the three strike prices, so listen up!
What Does Out of the Money (OTM) Mean With Options?
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. The video above explains how it works when purchasing an options contract. Out of the money is a term used to describe call and put options. There are three types of contracts and there are many moving parts that make up options trading.
What are options? Options trading gives you the right but not the obligation to buy (call) or sell (put) a stock at a specific price (strike price).
Basics of Out of the Money
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. Make sure to learn how to trade weekly options.
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 (check out our swing trading strategies page).
Options Contracts 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.
One options contract controls 100 shares. It is less expensive to exercise a contract than buying 100 shares of a stock outright. However, don’t forget the moving parts that affect a stock’s price. Take our option trading course to learn more.
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.
No matter what trading style you employ, support and resistance is necessary. You can find it using candlesticks; i.e. the most important way to find it.
You can also use moving average lines and patterns.
Patterns and Technical Analysis
If you’re looking to buy otm options contracts hoping they go in the money, you need to look at the charts. What patterns do you see?
Are the patterns reversal patterns or continuation patterns? Patterns are so important! They not only show you what a stock can do but also provide support and resistance.
You can use technical analysis to confirm everything as well. It’s not a crystal ball into a stocks future. However they’re great tools to help tune out the noise and take the emotion out of trading.
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. It’s a type of strategy employed in diagonal spreads for example. Thanks for reading!