An Out of the Money (OTM) option is a financial derivative that has no intrinsic value. For a call option, this means the strike price is higher than the current market price of the underlying asset. Conversely, for a put option, the strike price is lower than the current market price of the underlying asset. Therefore, the option would not be profitable if it were exercised immediately.
KaTeX Formula for Call Options
For a call option, the condition for being out of the money can be represented as:
KaTeX Formula for Put Options
For a put option, the condition for being out of the money can be represented as:
Types of Out of the Money Options
Call Options
- Definition: A call option gives the holder the right, but not the obligation, to purchase a stock or other asset at a specified strike price.
- OTM Condition: For a call option to be OTM, the strike price must be greater than the current market price of the underlying asset.
Put Options
- Definition: A put option allows the holder the right, but not the obligation, to sell a stock or other asset at a specified strike price.
- OTM Condition: For a put option to be OTM, the strike price must be less than the current market price of the underlying asset.
Special Considerations
Time Value and OTM Options
OTM options usually contain only time value and no intrinsic value. The time value of an OTM option is influenced by several factors including volatility, time until expiration, and interest rates.
Usage in Strategies
OTM options are often used in various trading strategies, including spreads and speculative positions, due to their lower premiums compared to at-the-money (ATM) or in-the-money (ITM) options.
Risk and Reward
OTM options are riskier than ITM or ATM options because they require a significant move in the price of the underlying asset to become profitable. However, they also offer higher percentage returns if the underlying asset moves in favor of the option holder.
Examples
Call Option Example
Consider a stock currently trading at $50. A call option with a strike price of $55 would be considered OTM because the strike price is higher than the current market price.
Put Option Example
Consider a stock currently trading at $50. A put option with a strike price of $45 would be considered OTM because the strike price is lower than the current market price.
Historical Context
Options trading dates back to ancient Greece and Rome but became more systematized in the 20th century with the establishment of exchanges like the Chicago Board Options Exchange (CBOE) in 1973. The concept of OTM has always been crucial, given the economic principles of risk and reward.
Applicability
OTM options are widely used in financial markets for speculative purposes, income generation (through writing options), and as part of more complex strategies like straddles and strangles.
Related Terms
- In the Money (ITM): An option with intrinsic value (e.g., a call option with a strike price below the market price).
- At the Money (ATM): An option with a strike price approximating the current market price.
FAQs
What happens if an OTM option expires?
Can OTM options become profitable?
Why do traders buy OTM options?
References
- Hull, J.C. (2021). “Options, Futures, and Other Derivatives”. Pearson.
- Black, F., & Scholes, M. (1973). “The Pricing of Options and Corporate Liabilities”. Journal of Political Economy.
Summary
Out of the Money (OTM) options are a critical concept in options trading. These options, whether calls or puts, have strike prices that are less favorable than the current market price of the underlying asset. While OTM options are riskier due to their lack of intrinsic value, they offer potential for significant returns if the market moves in the right direction. Understanding OTM options is essential for anyone involved in the financial markets.
