Out of the Money (OOTM)

What Is Out of the Money (OTM)?

The term “out-of-the-money” (OOTM) is used to describe the status and value of an option contract. An option contract can either be out-of-the-money, in-the-money, or at-the-money.

So what do these terms mean? 

Well, they describe the relationship between an option’s current price in the market and the contract's strike price. 

Out-of-the-money options are option contracts that have no intrinsic value. OOTM options only have extrinsic value because the intrinsic value of the option is the value of the option if it were exercised

When an option is out-of-the-money, it is not profitable to exercise the contract. Call options are out-of-the-money when the current market price is lower than the contract’s strike price.

Put options are deemed out-of-the-money when the current market price exceeds the contract’s strike price. 

Out-of-the-money options are less expensive than ATM or ITM options because OOTM options do not have any intrinsic value. Therefore, OOTM options rely solely on extrinsic factors such as:

• Time until expiration
• Volatility
• Interest Rates
• Supply and Demand of the Contract 

With that being said, OOTM options have a very important role in derivatives trading.

Although OOTM options have no intrinsic value in exercising the contract, OOTM options can still be used in more complex trading strategies such as: 

• Speculating that the option will become ITM
• Buying the OOTM option and selling it before exercising (Flipping)
• Hedging
• Writing Options

In this article, the general topic of options contracts will be covered, with a more in-depth analysis of out-of-the-money options.

Options Basics

Options are a type of financial instrument that represents 100 shares of stock. These types of financial instruments can be bought and sold like other financial assets; however, they are contracts that give buyers the ability to choose whether they want to buy shares upon expiration.

Options have strike prices, which allow contracts to be exercised (bought or sold) once they surpass a certain price. 

Options also have expiration dates, which tell investors when the contract will expire worthless.

Options can be more risky than buying shares of stocks, but also much more rewarding. This is because one option contract represents 100 shares of a stock, so as the stock price moves, the option contract moves more drastically.

Essentially, options allow investors to own leveraged positions in contracts that are traded to mimic the performance of the company's stock prices.

Here are things investors can do with options contracts:

• Buy or Sell
• Calls or Puts

1. Buying Calls 

Buying a call gives investors the right to buy shares at a stated strike price. Since owning a call option directly correlates with the underlying stock’s price, as the stock price increases, the value of the contract also increases, and vice versa. 

Buying calls can be considered a bullish position in the market, and the maximum loss that a call holder can take is the value of the premium paid for the contract.

2. Buying Puts

Buying a put gives investors the right to sell shares at a stated strike price. Since owning a put option is directly related to the inverse of a stock’s price, a put option’s value increases as a stock’s price decreases, and vice-versa.

A put option is a bearish position in the market and is considered a short. The maximum loss a holder of a put can incur is the initial premium paid.

3. Selling Calls

Although you don’t necessarily have to own shares of the company to sell a call option, selling a call is a type -of option where the buyer pays an initial premium investment to the seller, in which the seller pockets if the stock’s market price never reaches the strike price. 

If the market price reaches or climbs beyond the strike price, then the seller must sell their portfolio’s shares to the buyer. Or, if the seller doesn’t own the shares, they must purchase them at a high strike price and sell them back to the buyer at a lower market price.

Selling calls is a bearish strategy that investors use when they believe a stock’s price will decrease or remain lower than the strike price.

The seller loses more on this option the further the stock price is below the strike price. Hence, the risk for selling call options is technically unlimited because a stock’s price can increase to infinity.

For example, if the asset’s price increases tremendously, the seller must purchase one hundred expensive shares of the stock upon the buyer’s decision to exercise.

4. Selling Puts

Selling a put is a type of options contract where the seller collects a premium from the buyer, which the seller collects if the stock price doesn’t decline to the put option’s strike price.

If the stock’s price goes below the strike price, the buyer can exercise and sell the shares back to the seller, who is obligated to buy those shares at a price that is lower than market value.

In essence, the seller is betting on the contract remaining out of the money so that the buyer does not have the chance to exercise the contract. 

This is because the seller has to purchase the shares from the buyer, and they would incur losses if they buy shares at a strike price higher than what the asset is actually worth.

Selling puts is a bullish strategy, and investors use it when they believe that a stock’s price will remain or move higher than the put option’s strike price.

In this case, the risk of the option is simply the difference between the strike price and the market price, but it is important to remember that the risk is limited due to the fact that stocks can only drop to the value of 0.

Options Trading Terms

Exercising an option refers to a buyer's ability to purchase the underlying shares in the option contract. If the contract is ITM, exercising would be profitable. If the contract is OOTM, exercising would not be profitable. 

Assignment regarding options trading is very important in selling call or put contracts. The assignment represents the seller’s obligation to buy or sell the shares depending on whether they sold a call or put option. Assignment occurs when the buyer chooses to exercise.

An option’s premium is the initial price that an option buyer pays to a seller to write a contract, where the right to buy or sell 100 shares of security is given to the buyer. 

The premium is determined by various factors, including the underlying asset's current price, the option's strike price, the time remaining until expiration, and market volatility.

Essentially, the premium can be determined by any factors affecting the probability of the option being profitable. 

For instance, options that have strike prices further from the current market price have cheaper premiums and vice versa. This is because it is less likely to hit the strike price.

Important risk factors also influence options contracts called the Greeks. The Greeks are:

1. Delta
2. Gamma
3. Theta
4. Vega 
5. Rho

Spread Options Vs. Option Spreads 

Although these terms can be easily mixed up due to the word “spread”, these are entirely different aspects of trading options. 

Spread options are a form of options trading where a contract derives its value from multiple securities. Rather than a singular price, spread options are based on the spread, gap, or difference between two assets’ prices.

There is also a strategy dealing with option contracts called option spreads.

Option spreads refer to using multiple options contracts on the same stock to create more complex positions than just long or short ones.

There are three main types of option spreads:

• Vertical: Vertical spreads involve options from the same class, underlying security, and expiration month but with different strike prices.
• Horizontal: Horizontal or calendar spreads involve options with the same underlying security and strike prices but different expiration dates.
• Diagonal: Diagonal spreads involve options with the same underlying security, but they have different strike prices and expiration dates.

These spreads are classified based on how the options' strike prices and expiration dates are related.

Options: Intrinsic Value

OOTM options have no intrinsic value; however, if the stock price moves favorably, the option could become intrinsically valuable if it is ITM. 

In this section, we will discuss what intrinsic value means to better understand all types of options and what could make them OOTM. 

Intrinsic value and extrinsic value are the two components that make up the total value of an options contract.

Intrinsic value is the difference between the stock's current market price and the contract's set strike price. In literal terms, the intrinsic value is the profit an investor would make if they chose to exercise the contract at that exact moment. 

Intrinsic value can never be negative, and if an option has no intrinsic value, it is simply labeled as OTM.

Here are formulas for calculating the intrinsic value of an option contract for both calls and puts. 

For calls:

Call option intrinsic value = underlying stock’s current price - strike price

For puts:

Put option intrinsic value = strike price - underlying stock’s current price

Now, what about the intrinsic value of out-of-the-money options?

OOTM options have no intrinsic value because their strike price is unfavorable to exercise in relation to the underlying asset's current price. Conversely, ITM options would have intrinsic value due to their favorable position concerning the strike place.

Options: Extrinsic Value

Out-of-the-money options are highly affected by the factors that also affect extrinsic value since OOTM options only have extrinsic value.

An option's extrinsic value is the value of an option beyond its intrinsic value. In other words, it is the value an option has if it no longer has any intrinsic value. Extrinsic value is influenced by external factors such as

• Time remaining until expiration
•  Volatility
•  Implied Volatility (IV)
•  Interest rates
•  Investor sentiment

It is clear that the more time an option has until expiration and the higher the volatility, the greater the potential for price movements that could make the option profitable. Extrinsic value, though, can diminish over time and eventually reach zero at the time of expiration.

Determining an Option’s Value

Here's how this looks for both call and put options.

1. For Call Options

An OOTM call option has a strike price higher than the underlying asset's current price. Since the option holder would not benefit from buying the asset at a higher price than its current market value, the call option has no intrinsic value.

2. For Put Options

An OOTM put option has a strike price lower than the underlying asset's current price. In this case, the option holder would not benefit from selling the stock at a lower price than its current market value. Hence, the put option also has no intrinsic value.

3. For OOTM Option Holders

The extrinsic value that it still has represents the potential for the option to become profitable before expiration. This is due to factors such as changes in the underlying asset's price or market conditions affecting the value of the contract before expiry.

Option holders of OTM options hope that the option may move into the money (ITM) before expiration to gain intrinsic value. However, the option holder may not care if the option is ITM or OOTM because they can sell the contract for a profit if its price increases.

4. For Sellers of Options

OOTM and no intrinsic value means there is a higher probability that the option will expire worthless, allowing them to keep the premium they received when selling the option.

If the option remains OTM at expiration, the seller does not need to fulfill any obligations related to the option contract, and they can keep the entire premium as profit.

Out-of-the-Money Options

OOTM options only have extrinsic value, but investors can still use them to make profits.

An investor could purchase an out-of-the-money option for a premium price of $50 and then sell it two days later for a premium of $70.

Volatility is extremely important for OOTM options because it is what has the potential to affect the contract the most in a day. When volatility increases, the extrinsic value of OOTM options tends to rise, making them more expensive.

This relationship between OOTM options and volatility is an essential aspect of options trading, and it can be utilized for effective day trading of options contracts.

The strike price is an important aspect of OOTM options. The strike price is the market price at which a call option’s shares can be bought. For put options, it is the price at which the contract’s shares can be sold.

With the strike price, we can easily deem a contract ITM or OOTM if we know the current market price of the option’s stock shares.

If a call option has a listed strike price of 80 and the stock price is currently at 70, we would say it is out of the money based on those two pieces of information.

On the other hand, if a put option has a listed strike price of 60 and the stock price is currently at 70, this option would be considered out-of-the-money. 

As previously mentioned, these out-of-the-money options still have value because the price could rise at any point in time. Even if the price never hits the strike price by the expiration date, the option owner could sell the option for a profit at any point. 

Now that we understand options contracts well, let’s examine what OOTM means in the context of call options and put options.

An out-of-the-money option means something completely different for calls and puts, which are the two types of options. 

1. OOTM Calls

To consider a call out-of-the-money, the market price must be lower than the strike price.

Calls can be bought in the money or out-of-the-money; however, it is worth noting that ITM options are much more expensive than OOTM options due to ITM options’ intrinsic value.

The higher cost of ITM options is mainly due to the inclusion of intrinsic value, which OOTM options lack.

Call options can only be exercised if the stock’s market price exceeds the strike price.

2. OOTM Puts

To consider a put option out-of-the-money, the market price must be higher than the strike price.

Puts are more expensive when the stock price is lower, and the further the market price is below the strike price, the more expensive the put option gets.

Now that we know how out-of-the-money applies to both call and put options, we will examine some examples to understand the concept better.

OOTM Call Example

Suppose you are interested in trading options on a stock called “A”. The current market price of “A” is $50 per share. 

You decide to explore call options on “A” with a strike price of $60 and an expiration date one month out from now. This means that if you eventually decide to exercise the option (assuming ITM), you have the right to buy shares for $60 each.

In this example: 

• The stock's current market price ($50) is lower than the call option's strike price ($60).
• In this scenario, the call option is currently considered "out-of-the-money" because exercising it immediately would not be profitable. 

This is because you could buy shares directly from the market for a lower price ($50) instead of paying $60 through the option’s listed strike price.

• Let's assume that this same call option is trading at a premium of $2. This means that as an options trader, you would need to pay $2 per share to acquire the call option.

If the stock price remains below $60 until the option's expiration, the option will remain OOTM and expire worthless. In this case, the buyer would lose the initial premium paid.

However, the call option could become very profitable if the stock price rises above $60 before expiration.

For example, if the stock price rises to $65 per share before the option expires, the call option with a strike price of $60 would now be "in the money" by $5. 

You could exercise the option and buy shares for $60, then sell them immediately in the market for $65, resulting in a $5 profit per share.

If the stock rises to $55 per share, and you want to sell the option to exit the risky position and take some profit, the option can be sold at any time regardless of if it is OOTM or ITM; ITM would just give the option intrinsic value and the ability to exercise.

OOTM Put Example

Suppose you are looking at options for a stock called “B”. 

• The current market price of “B” is $80 per share.
• You think the stock will decrease in the next few months, so you decide to explore puts.
• Let’s say these options on “B” have a strike price of $70 and an expiration date of three months. 

This means that if you were to exercise the put option, you have the right to sell the shares for $70 each.

In this scenario:

• The current market price of “B” ($80) is higher than the strike price of the put option ($70).

As you should be able to recognize by now, the put option is considered "out-of-the-money" because exercising it immediately would not be profitable. 

This is because you could sell “B” shares in the market for a higher price ($80) instead of selling them for a lower price of $70 through the option.

Let's assume that the put option is trading at a premium of $3. This means you pay $3 per share to acquire the put option.

If the stock price remains above $70 until the option's expiration, the option will expire worthless. In this case, you would lose the premium paid for the option ($3 per share) as it would not have any intrinsic value. 

However, the put option could become profitable if the stock price falls below $70 before expiration.

For example, if “B”  stock price drops to $65 per share before the option expires, the put option with a strike price of $70 would now be "in the money" by $5. 

Now you could exercise the option and sell the shares for $70, even though their market value is only $65, resulting in a $5 profit per share.

It is worth noting that the option can be sold at any point, whether ITM or OOTM.

Now, you should be able to define an option contract and what could make it out of the money.

Researched & Authored by Alex Bellucci | LinkedIn

Reviewed and edited by Naveeth Rishwan Habeeb | LinkedIn

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