SteadyOptions is an options trading forum where you can find solutions from top options traders. Join Us!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Out Of The Money (OTM) Options Explained


Out of the money (OTM) options: where the exercise price for a call is more than the current underlying security’s price (or less for a put). This is an example of ‘moneyness’ – a concept which considers the strike price of an option in relation to the current stock price.

Let’s look at a couple of examples:

Out Of The Money Call Option

out of the money call option

 

Suppose a trader owns a 140 IBM Call Dec 20 call option allowing them to buy IBM stock at $140/share anytime between now and Dec 2020.

 

This call is said to be out of the money if the stock is less than $140, at $134 say.

 

There would be no point exercising this option, and buying the stock at $140, as it is available on the market for $134.

 

Out Of The Money Put Option

out of the money put option

 

Likewise the owner of a 130 IBM Put Dec 20, allowing them to sell IBM stock for $130 anytime between now and Dec 2020, would not exercise this option as they could get a better price, $134, in the open market.

 

Hence the put is out of the money too.

 

Intrinsic Value: OTM Options

Out of the money options have no intrinsic value (unlike in ITM Options).

 

A call’s intrinsic value is defined as the discount to the stock price enjoyed by the owner of these options. As, by definition, there is no such discount (out-of-the money calls’ strike price is higher than the stock price) there is no intrinsic value.

 

Similarly the intrinsic value of a put, any premium of exercise price over the stock price, is zero too.

 

(Intrinsic value cannot be negative).

 

Extrinsic Value Of Out-Of-The-Money Options

Extrinsic value is defined as the option price less intrinsic value. As an OTM option has no intrinsic value (see above) all its value is extrinsic.

 

Options beginners struggle with this. Why, they ask, does an option that is, say, $6 out of the money (such as the 140 Dec 20 call above) have any value if a buyer could just buy the stock for a lower price. Wouldn’t the fair value of an OTM option be zero?

 

Extrinsic Value Example

Well, again looking at above call example, what the owner of the option is buying is the chance that it will move to be in the money (ie above $140) sometime between now and Dec 2020.

 

Suppose the stock price rose to $150 at expiry (for simplicity). The option holder would profit by $10 – they could exercise their $140 option and sell at $150. Indeed their upside is unlimited – the stock could be even higher.

 

Their downside is zero (excluding the cost of the option) however. No loss would be made If the underlying stayed below $140 as there is no obligation to exercise the option.

 

Optionality & Option Valuation

This ability to enjoy unlimited upside but no downside has a value – the call’s so called ‘optionality’. This value is what powers an OTM option’s price.

 

But how to quantify this value? How would we price the 140 Call, with the stock at $134? That’s for the market to price. But in general its value is mainly determined by:

  • The amount it is out of the money: you’d pay less for a 150 call, $16 out of the money, than the closer to the money $140 call for example.
     
  • How volatile the stock is. The IBM share price is likely to be much steadier than, say, a start-up. Hence it is much less likely to jump up to the $140 before Dec 2020. Therefore the IBM call option is likely to be worth less. The market’s view of a stock’s future volatility is called implied volatility
     
  • How long to expiry. If there is a long time between now and the option expiration date then it is more likely to cross $140. Therefore, all other things being equal, it is more valuable than a shorter dated option.

(There more on how options work here)
 

Behavior Of OTM Options On Expiry

Following on from the last point above, the option has no extrinsic value if there is no time left to expiry as there is no optionality (the stock can never rise to be in the money).

 

Because it has no intrinsic value either (see above) OTM options expire worthless on expiry.

 

This makes sense. If the above option, for example, expires with the stock price below $140, the option holder will be able to buy stock at $140.

 

But they can buy it for less, $134, on the market and so the option has no value to him/her.

 

An option will expire worthless if it is out of the money as (per the above examples). The market will provide a better price for both buying (call) and selling (put options).

 

Conclusion

Out of the money call/put options are those that are above/below the strike price and have no intrinsic value.

 

They do have extrinsic value – caused by a holder potentially making money if the stock moves.

 

The market’s view of the stock’s future volatility (i.e. its implied volatility), how far the strike price is from the stock price and time to expiry are the main factors that influence an option’s market price.

 

If an option expires out of the money it is worthless.

About the Author: Chris Young has a mathematics degree and 18 years finance experience. Chris is British by background but has worked in the US and lately in Australia. His interest in options was first aroused by the ‘Trading Options’ section of the Financial Times (of London). He decided to bring this knowledge to a wider audience and founded Epsilon Options in 2012.

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Real-time trade sharing: entry, exit, and adjustments

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Subscribe to SteadyOptions now and experience the full power of options trading!
Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Retirement Strategies for Senior Citizens to Grow and Protect Their Wealth

    Retirement is a time of life that many people look forward to, but it requires careful planning and preparation. One of the most important aspects of preparing for retirement is calculating your retirement needs and starting to save early. In this section, we will discuss some key points to consider when planning for your retirement.

     

    By Kim,

    • 0 comments
    • 316 views
  • Seagull Spreads

    A seagull spread involves adding an additional short option to a vertical debit spread to reduce the net debit paid, often enabling you to enter a trade for zero cost. The name is derived from the fact that the payoff diagram has a body and two wings, imitating a seagull.

    By Pat Crawley,

    • 0 comments
    • 4,741 views
  • The Options Wheel Strategy: Wheel Trade Explained

    The “wheel” trade is variously described as a beginner’s strategy, a combination to exploit features of both calls and puts, and as “perfect” solution to the well-known risks of shorting calls, even when covered. The options wheel strategy is an income-generating options trading strategy that both beginners and experienced traders can leverage for profit.

    By Pat Crawley,

    • 0 comments
    • 4,222 views
  • Covered Calls Options Strategy Guide

    Covered calls have always been a popular options strategy. Indeed for many traders, their introduction to options trading is a covered call used to augment income on an existing stock portfolio. But this strategy is more complicated, and riskier, than it looks.

    By Chris Young,

    • 0 comments
    • 439 views
  • How Options Work: Trading Put And Call Options

    Learning how options work is a key skill for any trader or investor wanting to add this to their arsenal of trading weapons. It’s really not possible to trade options well without having a thorough grounding of the mechanics of what these derivatives are and how they work.

    By Chris Young,

    • 0 comments
    • 631 views
  • Protective Put: Defensive Option Strategy Explained

    The protective put (sometimes called a married put) strategy is one of the simplest, but most, popular, ways options are used in the market. Here we look at this defensive strategy and when and how to put it in place. Options provide investors and traders with an extremely versatile tool that can be used under many different scenarios.

    By Chris Young,

    • 0 comments
    • 852 views
  • The Surprising Secret to Proper Portfolio Diversification Revealed

    During a discussion about my trading system, the question arose regarding the ability to exit positions entirely and mitigate substantial drawdowns during a crash-style event. This particular circumstance has caused concern about the effectiveness of the trading method. The common response to such concerns is often centered around the concept of maintaining a properly diversified portfolio.

    By Karl Domm,

    • 0 comments
    • 1,638 views
  • Options Trading Strategy: Bear Put Spread

    Options can be an extremely useful tool for short-term traders as well as long-term investors. Options can provide investors with a vehicle to bet on market direction or volatility, and may also be used to collect premiums. A long options position is simple to use, and has defined risk parameters.

    By Chris Young,

    • 0 comments
    • 1,571 views
  • Market Chameleon Trial Offer

    We are pleased to announce that Market Chameleon is offering SteadyOptions members a 2 week free trial for their premium tools. Market Chameleon is a premier provider of options information, using both stock fundamentals data as well as options analytics to provide better insight for those who wish to make informed investment decisions.

     

    By Kim,

    • 0 comments
    • 1,716 views
  • Where Should You Be Investing Your Money?

    Everyone should be investing. After all, there’s no better way to increase your retirement savings and boost your spending power than by putting your money to work. Many people believe that investing is something that only wealthy people or financial experts can do, but that’s not the case.

    By Kim,

    • 0 comments
    • 1,572 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido