In the world of options trading, understanding key terms is essential for making informed decisions. One of the most fundamental concepts is "Out of The Money" (OTM). Whether you're new to trading or looking to refine your strategies, grasping what OTM means and how it compares to other key states like "In The Money" (ITM) is crucial.
Defining Out of The Money (OTM)
An option is considered Out of The Money (OTM) when its strike price is not favorable compared to the current market price of the underlying asset.
- For a call option, this occurs when the strike price is higher than the market price.
- For a put option, it happens when the strike price is lower than the market price.
In simple terms, an OTM option has no intrinsic value. If the market price doesn't move in the option holder's favor before expiration, the option will expire worthless, offering no profit from being exercised.
A Practical Example of OTM
Let's make this concrete with an example. Imagine you purchase a call option for a stock with a strike price of $80.
- If the current market price of that stock is $75, your call option is **Out of The Money**. You would not exercise your right to buy the stock at $80 when you could simply buy it on the open market for $75.
- Conversely, if you hold a put option with an $80 strike price, it would be OTM if the market price is $85 or higher. You wouldn't want to sell the stock for $80 when its market value is greater.
Out of The Money (OTM) vs. In The Money (ITM)
To fully appreciate OTM, it's best to compare it directly with its opposite: In The Money (ITM).
What Is In The Money (ITM)?
An option is In The Money when its strike price is favorable compared to the current market price, giving it positive intrinsic value.
- A call option is ITM when its strike price is lower than the market price.
- A put option is ITM when its strike price is higher than the market price.
An ITM option is immediately profitable if exercised because it allows the holder to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a better-than-market price.
Key Differences Between OTM and ITM
The core difference lies in the intrinsic value of the option.
- Intrinsic Value: This is the real, tangible value of an option if it were exercised immediately. ITM options have positive intrinsic value, while OTM options have zero intrinsic value.
- Cost: ITM options are significantly more expensive to purchase than OTM options. This higher premium is due to their existing intrinsic value and higher probability of finishing profitable.
- Risk and Reward Profile: ITM options are generally considered less risky because they already have value. However, they offer lower leverage. OTM options are much cheaper and riskier, but they offer the potential for much higher percentage returns if the market makes a significant move in the predicted direction.
| Feature | Out of The Money (OTM) | In The Money (ITM) |
|---|---|---|
| Intrinsic Value | Zero | Positive |
| Option Premium | Lower | Higher |
| Risk Level | Higher | Lower |
| Probability of Profit | Lower | Higher |
| Leverage Potential | Higher | Lower |
Can You Exercise an Out of The Money Option?
Technically, yes, you can exercise an OTM option. However, it is almost never beneficial for the holder to do so. Exercising an OTM call option would mean buying the asset above its market price, and exercising an OTM put would mean selling it below market price, resulting in an immediate loss.
There are extremely rare scenarios where a professional trader might exercise an OTM option, typically to manage complex risk or close a position near expiration to avoid potential gap risk over a weekend. For the vast majority of retail investors, exercising an OTM option is not a rational strategy.
When Might a Trader Use an OTM Option?
Despite their lack of intrinsic value, OTM options are popular trading instruments for specific strategies.
- Speculation on Price Movement: Traders buy cheap OTM options to bet on a significant price swing in the underlying asset. The low cost allows for high leverage; a small move can result in a large percentage gain.
- Defining Risk: When selling options, traders often use OTM strikes. The premium collected is their maximum profit, and the defined risk is the distance between the strike price and the market price.
- Hedging Portfolios: OTM put options can be used as inexpensive insurance to protect a stock portfolio against a sharp downturn.
Key Considerations Before Using OTM Options
If you're considering an OTM strategy, assess these factors:
- Time to Expiration: OTM options are extremely sensitive to time decay (theta). Their value erodes quickly as expiration approaches.
- Implied Volatility: The price of OTM options is heavily influenced by expected volatility. High volatility increases their premium.
- Probability of Profit: Use tools like delta to understand the market's implied probability of the option expiring ITM. Delta for OTM options is low.
Why Are OTM Options Cheaper?
OTM options cost less for several logical reasons:
- Zero Intrinsic Value: Their price consists entirely of "extrinsic" or "time" value.
- Lower Probability of Profit: The market perceives a lower chance that the underlying asset will move sufficiently to make the option profitable before it expires.
- Time Decay: The extrinsic value decays to zero at expiration, and this decay accelerates as the expiration date nears.
The Positive Aspects of OTM Options
The primary advantage of OTM options is their high leverage potential. Because they are cheap, a trader can control a large amount of shares for a small amount of capital. If the trade is successful, the return on investment can be substantial. This potential for outsized gains is what attracts speculative traders to OTM calls and puts.
OTM vs. ITM: Which Should You Use?
There is no one-size-fits-all answer. The choice between OTM and ITM options depends entirely on your trading objectives, risk tolerance, and market outlook.
- Use ITM Options if you are more conservative, seek a higher probability of profit, want to simulate owning the stock (e.g., for a dividend capture strategy), and are willing to pay a higher premium.
- Use OTM Options if you are a speculative trader with a strong conviction on a large price move, have a defined risk tolerance, are seeking high leverage, and are comfortable with a higher chance of losing your entire premium.
A balanced approach often involves using both types in different strategies to hedge risk and capitalize on various market conditions. 👉 Explore more strategies to find the right mix for your portfolio.
Frequently Asked Questions
What does "Out of the Money" mean?
"Out of the Money" describes an options contract that has no intrinsic value. For a call, the stock price is below the strike price. For a put, the stock price is above the strike price. It would be unprofitable to exercise the option immediately.
What is the main difference between ITM and OTM options?
The core difference is intrinsic value. ITM options have positive intrinsic value (you can exercise them for an immediate profit), while OTM options have zero intrinsic value. This makes ITM options more expensive and generally less risky than OTM options.
Why would anyone buy an OTM option?
Traders buy OTM options for their high leverage and low cost. They offer the potential for very high percentage returns if the underlying asset makes a large price move. They are primarily used for speculation or as a cheap form of portfolio insurance.
Can an OTM option become profitable?
Absolutely. If the market price of the underlying asset moves favorably—above the strike price for a call or below the strike price for a put—before expiration, the OTM option can move "In The Money" and become profitable to exercise or sell.
Are OTM options riskier than ITM options?
Yes, OTM options are considerably riskier. They have a much higher probability of expiring worthless, resulting in a 100% loss of the premium paid. Their value is also more susceptible to rapid decay due to time passage.
How does time decay affect OTM options?
Time decay, or theta, is the enemy of OTM option buyers. Since their value is purely extrinsic, it evaporates completely at expiration. The closer an OTM option gets to its expiry date, the faster it loses value, all else being equal.