What Are Out of the Money Options?
Grasp the essentials of Out of the Money options. Understand their valuation principles and how they compare to other option states.
Options are financial contracts that grant the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price by a specific date. These contracts are standardized and typically represent 100 shares of the underlying stock. Options are traded on regulated exchanges, similar to stocks, and their value fluctuates based on various market factors.
There are two primary types of options: call options and put options. A call option provides the holder the right to purchase the underlying asset, while a put option grants the right to sell the underlying asset. The price at which the asset can be bought or sold is known as the strike price, and the date by which the option must be exercised is called the expiration date.
Defining Out of the Money Options
An option is considered “Out of the Money” (OTM) when it possesses no intrinsic value, meaning it would not be profitable to exercise immediately. The entire value of an OTM option is derived from its time value, reflecting the possibility that the underlying asset’s price could move favorably before the option expires.
For a call option, it is Out of the Money if its strike price is higher than the current market price of the underlying asset. For example, if an investor holds a call option on Company A with a strike price of $50, and Company A’s stock is currently trading at $45 per share, that call option is Out of the Money. Exercising this option would mean buying shares at $50 that are currently worth only $45, resulting in an immediate loss.
Conversely, a put option is Out of the Money if its strike price is lower than the current market price of the underlying asset. Consider an investor with a put option on Company B with a strike price of $70, while Company B’s stock is trading at $75 per share. This put option is Out of the Money because selling shares at $70 that are currently worth $75 would lead to an immediate loss if exercised.
Understanding In the Money and At the Money Options
To understand OTM options fully, it helps to know about “In the Money” (ITM) and “At the Money” (ATM) options. These classifications, collectively known as “moneyness,” describe the intrinsic value of an option at any given moment.
An option is “In the Money” when it has intrinsic value, meaning it would be profitable to exercise immediately. For a call option, this occurs when the strike price is lower than the current market price of the underlying asset. For instance, if a call option on Company C has a strike price of $60 and Company C’s stock is trading at $65 per share, the option is In the Money, possessing $5 of intrinsic value per share.
For a put option, being In the Money means its strike price is higher than the current market price of the underlying asset. If a put option on Company D has a strike price of $90 and Company D’s stock is trading at $85 per share, this option is In the Money, carrying $5 of intrinsic value per share.
An option is considered “At the Money” when its strike price is approximately equal to the current market price of the underlying asset. For example, if a stock is trading at $100 per share, both a call option with a $100 strike price and a put option with a $100 strike price would be considered At the Money. These options have very little to no intrinsic value. Their value is almost entirely composed of time value, reflecting the potential for the underlying asset’s price to move favorably before expiration.
Key Characteristics of Out of the Money Options
OTM options inherently have no intrinsic value, meaning there is no immediate profit if exercised.
The entire premium paid for an Out of the Money option is composed solely of its time value, also known as extrinsic value. Time value reflects the remaining time until the option’s expiration date and the market’s expectation of future price movements, often influenced by implied volatility. As the expiration date approaches, the time value of an OTM option erodes, a phenomenon known as time decay.
Another significant characteristic of Out of the Money options is their higher probability of expiring worthless. If the underlying asset’s price does not move favorably beyond the option’s strike price before expiration, the option will expire unexercised and become worthless.