What Does Out of the Money Mean for Options?
Decode "out of the money" in options. Grasp this essential concept to better understand option pricing, risk, and potential outcomes.
Options trading involves contracts that derive their value from an underlying asset, such as a stock or commodity. These financial instruments offer both opportunities and risks, requiring a clear understanding of specialized terminology. For individuals exploring the options market, comprehending terms like “moneyness” is fundamental to making informed decisions.
Defining Moneyness in Options
The concept of “moneyness” describes the relationship between an option’s strike price and the current market price of its underlying asset. This relationship determines whether an option holds intrinsic value or only extrinsic value. Options can be categorized into three states of moneyness: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM).
An option is considered in-the-money when exercising it would result in an immediate profit, meaning it possesses intrinsic value. At-the-money options have a strike price that is approximately equal to the underlying asset’s current market price. In contrast, an option is out-of-the-money when its strike price makes exercising it unprofitable at the current market price.
Out-of-the-Money Call Options
A call option grants the holder the right, but not the obligation, to purchase an underlying asset at a specified strike price before or on the expiration date. A call option is out-of-the-money when the strike price is higher than the current market price of the underlying asset.
For example, if an investor holds a call option for ABC stock with a strike price of $50, and ABC stock is currently trading at $45, the option is out-of-the-money. The investor would not exercise the right to buy shares at $50 when they could purchase them in the open market for $45.
Out-of-the-Money Put Options
A put option gives the holder the right, but not the obligation, to sell an underlying asset at a specified strike price before or on the expiration date. A put option is out-of-the-money when the strike price is lower than the current market price of the underlying asset.
Consider an investor with a put option for XYZ stock at a strike price of $100, while XYZ stock is trading at $105. This put option is out-of-the-money because the investor would not choose to sell shares at $100 when they could sell them for $105 in the open market.
What Happens to Out-of-the-Money Options
The fate of an out-of-the-money option is straightforward as it approaches its expiration date. If an option remains out-of-the-money at expiration, it will expire worthless. This means the option holder loses the entire premium paid to acquire the option, as there is no financial incentive to exercise it.
Out-of-the-money options trade at lower premiums compared to in-the-money or at-the-money options. This lower cost reflects their reduced probability of becoming profitable before expiration, as they rely solely on the underlying asset’s price movement to become profitable. The premium of an out-of-the-money option consists entirely of its extrinsic value, which diminishes as expiration approaches.