“Out of the Money” (OTM) is a term used in options trading to describe a situation where an option’s strike price is less favorable compared to the current market price of the underlying asset. In simpler terms, for OTM options, if the option were exercised immediately, it would not be profitable.
Definition
An option is said to be Out of the Money when:
- For a call option: The strike price is higher than the market price of the underlying asset.
- For a put option: The strike price is lower than the market price of the underlying asset.
Exercising an OTM option would result in a loss, hence, it is typically not done unless the option holder expects a future favorability in asset’s price movement before expiration.
Types of Options and OTM
Call Options
A call option gives the holder the right, but not the obligation, to buy a specified quantity of an underlying asset at a set strike price before the option expires. A call option is OTM if the strike price is above the current market price of the underlying asset.
Put Options
A put option provides the holder the right, but not the obligation, to sell a specified amount of an underlying asset at a predetermined price before the option expires. A put option is considered OTM if the strike price is below the current market price of the underlying asset.
Special Considerations
Implied Volatility
Implied volatility can significantly affect the premium of OTM options. Higher implied volatility often increases the chance that an OTM option may become ITM (In the Money) before expiration, thus increasing its premium.
Time Decay
OTM options are more prone to the effects of time decay (theta). As expiration approaches, the extrinsic value of the OTM option decreases, making it less valuable and often cheaper.
Examples
-
Call Option Example:
- Strike Price: $100
- Current Market Price: $90
- Status: OTM (Exercising the call would mean buying at $100 when it can be purchased at $90 in the market, leading to no profit.)
-
Put Option Example:
- Strike Price: $100
- Current Market Price: $110
- Status: OTM (Exercising the put would mean selling at $100 when it can be sold at $110 in the market, leading to no profit.)
Historical Context
The term “Out of the Money” has been integral to options trading since the inception of modern financial markets and the formal establishment of options exchanges such as the Chicago Board Options Exchange (CBOE) in 1973. Understanding OTM has been essential for traders in devising strategies in volatile markets.
Applicability
Trading Strategies
OTM options are often used in speculative trading strategies and hedging. Traders may purchase OTM options if they anticipate significant movements in the underlying asset’s price. They are less expensive than ATM (At the Money) or ITM options, allowing for leveraging potential profits.
Related Terms
- In the Money (ITM): An option where exercising would be profitable.
- At the Money (ATM): An option where the strike price is very close or equal to the market price.
FAQs
Q: Why would someone buy an OTM option if it's not profitable?
Q: Can an OTM option become profitable?
References
- Hull, J. C. (2017). “Options, Futures, and Other Derivatives.” Pearson Education.
- CBOE. (n.d.). Glossary of Terms. https://www.cboe.com/glossary
Summary
“Out of the Money” options represent a crucial concept in options trading, particularly for understanding potential profitability and strategic deployment. While OTM options are not immediately profitable, they serve essential roles in hedging and speculative strategies due to their lower premiums and potential for significant price moves. Understanding the mechanics and implications of OTM options is key for traders in devising effective market strategies.
