Options contracts grant their owners the right (but not the obligation) to buy or sell a particular asset (usually 100 shares of a stock) at a particular price (the option’s strike price) until or upon the contract’s expiration. Call options grant their owners the right to buy an asset, while put options grant their owners the right to sell an asset.
What Does OTM Mean? Out of the Money Defined
An options contract is considered “out of the money” if it lacks intrinsic value, meaning that if its owner exercised it, they would pay more than the current market value for a stock (in the case of a call option) or sell a stock for less than its current market value (in the case of a put option).
In other words, a call option is out of the money if its strike price is higher than its spot price (market value), and a put option is out of the money if its strike price is lower than its spot price.
Out of the Money (OTM) vs. In the Money (ITM) Options
The opposite of out of the money is “in the money.” Options contracts that do have intrinsic value are considered in the money.
If a call option’s strike price is lower than the current market price of the underlying stock, it is in the money because its owner could exercise it in order to buy the stock for less than it’s worth. If a put option’s strike price is above the current market price of the underlying stock, it is in the money because its owner could exercise it in order to sell the stock for more than it’s worth.
What Happens When an Option Expires Out of the Money?
If an options contract reaches expiration while out of the money, it expires worthless because there is no point in exercising an option that lacks intrinsic value. When a contract expires OTM and worthless, its owner loses the premium they paid for it.
Option premiums are typically very low compared to the price of the underlying shares, so trading options is a fairly low-risk way to bet on the price movement of 100 shares of stock without needing a large amount of capital. If things don’t pan out and an option expires worthless, the most its owner stands to lose is the premium they paid for the option.
Do Out-of-the-Money Options Have Value? Are They Worthless?
Options that are out of the money may seem worthless, as there would be no point in exercising them. Why would someone want to exercise their right to sell shares for less than they’re worth or buy shares for more than they’re worth when they could buy or sell regular shares on the open market at market value instead?
In reality, options that are out of the money do still have value—they just don’t have intrinsic value. The value of an options contract is derived (almost entirely) from three things: its intrinsic value, its time value (how long remains until its expiration), and the volatility of the underlying stock or asset. Therefore, OTM options do have value. The longer until the contract’s expiration and the more volatile the underlying asset, the more value an OTM option has.
TheStreet Dictionary Terms
An option’s time value and the volatility of the underlying asset together make up a contract’s extrinsic value.
While exercising an OTM option would almost always be pointless, holding it would not necessarily be a bad idea. Take, for example, a call option on a highly volatile stock that is out of the money by only $5 and expires in a month. Because the underlying stock is volatile, there is a chance that it will go up by more than $5 within the remaining 30 days, causing the contract to move into the money before its expiration. If this happens, the contract’s owner can either exercise the option to buy shares (usually 100 per contract) of the underlying stock for less than their market value, or resell the contract for a higher premium (price) than they paid for it.
Even if an OTM option doesn’t move into the money, it can still be resold for a higher premium if it moves closer to the money. The closer an OTM option is to being in the money, the higher its premium, all other things being equal.
Note: The intrinsic value of an options contract is always included in its premium (sale price), so all other things being equal, OTM options are cheaper than ITM options. Thus, if an OTM option moves ITM, its owner can usually resell it for a higher premium than they paid and pocket the difference.
How Does the Moneyness of an Option Affect Its Premium?
An option’s premium, or sale price, is derived from its moneyness (degree of intrinsic value or lack thereof), how long remains until its expiration, and how volatile the underlying stock or asset tends to be. Of these three factors, moneyness is usually the most significant.
In every case, an option’s intrinsic value (how far in the money it is) is included in its premium. For instance, an option that is in the money by $10 might have a premium of $12. $10 of this would represent the option’s intrinsic value, and the remaining $2 would account for the time until expiration and the volatility of the underlying stock.
Frequently Asked Questions (FAQ)
Below are answers to some of the most common questions investors have about OTM options that weren’t already addressed in this article.
Can You Exercise an Option That Is Out of the Money?
In most cases, exercising an OTM option doesn’t make sense. Therefore, most options that don’t move into the money before expiration are allowed to expire worthless. That being said, options owners do always have the right to exercise before or upon expiration, even if their options are out of the money.
Why Would Someone Buy an Option That Is Out of the Money?
OTM options have relatively low premiums because no intrinsic value is included in their price. If an investor is bullish on a stock (i.e., they think it will go up in value), they might buy an OTM call or put with the hopes of reselling it for a higher premium once the underlying stock goes up in value and moves into the money (or at least closer to being in the money).
Alternatively, if the option moves into the money, they might exercise it rather than reselling it in order to purchase shares for under market value or sell shares for over market value.
When Is a Call Option Out of the Money?
A call option is OTM when its strike price is higher than its spot price (the current market value of the underlying equity). This means that if it were exercised, the option’s owner would buy shares for more than they’re worth.
When Is a Put Option Out of the Money?
A put option is OTM when its strike price is lower than its spot price. This means that if it were exercised, the option’s owner would sell shares for less than they’re worth.