An out of the money (OTM) option is a term used in finance to describe an option contract that currently holds no intrinsic value, only extrinsic or time value. This type of option is attractive due to its lower cost compared to in-the-money (ITM) options and at-the-money (ATM) options.
Types of Out of the Money Options
Call Options:
- A call option is considered “out of the money” if the current price of the underlying asset is below the strike price of the option.
- Example: If an option’s strike price is $50, and the underlying asset is trading at $45, the call option is OTM.
Put Options:
- Conversely, a put option is “out of the money” when the underlying asset’s price is higher than the option’s strike price.
- Example: If a put option’s strike price is $30, and the asset is trading at $35, the put option is OTM.
Characteristics of Out of the Money Options
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Intrinsic Value: OTM options have no intrinsic value. This means they cannot be exercised profitably if they are held until expiration.
$$ \text{Intrinsic Value}_{\text{call}} = \max(0, \text{Underlying Price} - \text{Strike Price}) $$$$ \text{Intrinsic Value}_{\text{put}} = \max(0, \text{Strike Price} - \text{Underlying Price}) $$ -
Extrinsic or Time Value: The value of OTM options is entirely from their extrinsic value, which includes time value and volatility measures.
$$ \text{Option Price} = \text{Intrinsic Value} + \text{Extrinsic Value} $$ -
Cost: OTM options are generally less expensive than ITM options because they are further from the range needed for a profitable exercise.
Special Considerations
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Volatility: Greater market volatility can increase the extrinsic value of OTM options, making them more expensive.
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Time Decay: As an option approaches its expiration date, its extrinsic value diminishes—a process known as time decay or theta decay.
Examples and Scenarios
Example Scenario 1: Call Option
- Strike Price: $50
- Underlying Asset Price: $45
- The call option is out of the money.
- Intrinsic Value: $0
- Extrinsic Value: Derived from expectation and volatility, say $2.
- Price of Call Option: $2
Example Scenario 2: Put Option
- Strike Price: $30
- Underlying Asset Price: $35
- The put option is out of the money.
- Intrinsic Value: $0
- Extrinsic Value: Derived from expectation and volatility, say $1.50.
- Price of Put Option: $1.50
Historical Context
Options trading dates back to ancient Greece, but modern options markets developed substantially during the 20th century with the establishment of formal exchanges like the Chicago Board Options Exchange (CBOE) in 1973.
Comparisons with Other Option Types
- In the Money (ITM): An ITM option has intrinsic value and offers a higher chance of profitability but comes at a greater cost.
- At the Money (ATM): An ATM option’s strike price is approximately equal to the underlying asset’s price, making it a balance between cost and probability of payoff.
Related Terms
- Intrinsic Value: The value representing the amount by which an option is in the money.
- Extrinsic Value: Also known as time value, it refers to the remainder of the option’s price that is not intrinsic.
- Theta Decay: The erosion of the extrinsic value of an option as it approaches expiration.
FAQs
Q: Why would investors choose OTM options? A: Investors select OTM options primarily for their lower cost and potential for higher percentage gains if the underlying asset price moves favorably.
Q: What is the risk associated with OTM options? A: The main risk is that they can expire worthless if the underlying asset does not move in the desired direction.
Q: Can OTM options become ITM? A: Yes, if the underlying asset’s price moves past the strike price before expiration, an OTM option can become ITM.
References
- “Options, Futures, and Other Derivatives” by John C. Hull.
- Chicago Board Options Exchange (CBOE) Website
Summary
Out of the Money (OTM) options play a critical role in options trading strategies by offering cost-efficient speculative or hedging opportunities. While they are less expensive, they carry higher risks and depend heavily on market volatility and time remaining until expiration. Understanding their characteristics, price movement, and market context is essential for leveraging them effectively in trading strategies.
