What Is an Out-of-the-Money Call Option?
Grasp out-of-the-money call options. Discover their fundamental definition, how their value operates, and the path to potential profitability.
Options trading involves financial contracts whose value comes from an underlying asset, like a stock. These contracts allow investors to manage risk or speculate on price movements without directly owning the asset. This article explains out-of-the-money call options.
What Defines an Out-of-the-Money Call
A call option is a financial contract that grants the buyer the right, but not the obligation, to purchase an underlying asset at a specified price (strike price) on or before a certain date (expiration date). Each standard option contract typically represents 100 shares. The buyer pays a premium for this right, allowing them to benefit from an asset’s price increase without outright ownership.
An out-of-the-money (OTM) call option exists when the underlying asset’s current market price is below the call option’s strike price. For example, if a stock trades at $50, a call option with a $55 strike price is OTM. Exercising it immediately would mean buying the asset above its market value, resulting in a loss. An OTM call option holds no intrinsic value.
Understanding Value in OTM Calls
The price paid for an option, known as the premium, is composed of two elements: intrinsic value and time value. Intrinsic value represents the immediate profit if the option were exercised. For an out-of-the-money call option, intrinsic value is zero because the underlying asset’s price is below the strike price.
Despite having no intrinsic value, OTM call options possess time value. This component of the premium reflects the possibility that the option could become profitable before its expiration date. Factors influencing an OTM call option’s time value include the remaining time until expiration and the implied volatility of the underlying asset. Options with more time until expiration generally have higher time value due to a greater chance for favorable price movement. As the expiration date approaches, this time value erodes, a phenomenon known as time decay.
Path to Profitability for OTM Calls
For an out-of-the-money call option to become profitable for the buyer, the underlying asset’s price must increase sufficiently before or at expiration. Specifically, the price needs to rise above the strike price and also cover the premium initially paid for the option. This point, where the underlying asset’s price equals the strike price plus the premium paid per share, is known as the breakeven point.
For example, an investor buys an OTM call option with a strike price of $55 for a premium of $2.00 per share, representing a total cost of $200 for one contract (100 shares). For this option to be profitable, the stock’s price must rise above $55 and exceed the $2.00 premium. The breakeven point would be $57.00 ($55 strike price + $2.00 premium).
If the stock price reaches $60 by expiration, the option would be “in-the-money,” and the investor could exercise it to buy shares at $55 and sell them in the market at $60, realizing a gross profit of $5.00 per share. After accounting for the $2.00 premium, the net profit would be $3.00 per share, or $300 per contract, before commissions and fees. If the underlying asset’s price does not surpass the breakeven point by expiration, the option will expire worthless, and the buyer will lose the entire premium paid.
Comparing OTM, ATM, and ITM Call Options
Options are categorized into three states of “moneyness” based on the relationship between the underlying asset’s current price and the option’s strike price: out-of-the-money (OTM), at-the-money (ATM), and in-the-money (ITM). An OTM call option has a strike price higher than the underlying asset’s current market price, resulting in no intrinsic value. These options are typically less expensive due to their speculative nature.
An at-the-money (ATM) call option occurs when the strike price is approximately equal to the current market price of the underlying asset. Like OTM options, ATM calls have no intrinsic value, with their premium consisting entirely of time value. They represent a neutral position where the underlying asset has not yet moved significantly in favor of the option holder.
In-the-money (ITM) call options have a strike price lower than the current market price of the underlying asset. They possess intrinsic value, as immediate exercise would result in a profit. ITM options are generally more expensive due to this inherent value and their higher probability of expiring profitably.