In financial markets, options can be categorized based on their intrinsic value relative to the underlying asset. An option is considered Out of the Money (OTM) when it holds no intrinsic value. Specifically, this occurs when the strike price of a call option is higher than the current market price of the underlying asset, or when the strike price of a put option is lower than the current market price.
Definition and Types
Call Options
For call options, which grant the right to buy an asset at a predetermined price (strike price):
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OTM Call Option: The option’s strike price is greater than the current market price of the underlying asset.
\( \text{Current Market Price} < \text{Strike Price} \)
Example: If a stock is trading at $100, a call option with a strike price of $110 is OTM.
Put Options
For put options, which grant the right to sell an asset at a predetermined price (strike price):
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OTM Put Option: The option’s strike price is less than the current market price of the underlying asset.
\( \text{Current Market Price} > \text{Strike Price} \)
Example: If a stock is trading at $100, a put option with a strike price of $90 is OTM.
Special Considerations
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Intrinsic Value: Since OTM options have no intrinsic value, they are composed solely of time value or extrinsic value. This diminishes as the option approaches its expiration date.
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Volatility Impact: OTM options are more sensitive to changes in volatility. Higher volatility increases the probability that they may end up in the money (ITM) before expiration, thereby potentially increasing their premium.
Historical Context
The concept of options dates back to ancient Greek and Roman markets, but the modern options market began in the early 20th century. The Chicago Board Options Exchange (CBOE) was established in 1973, introducing standardized options contracts, which led to the current understanding of terms like ITM, ATM (At the Money), and OTM.
Examples
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Call Option: An investor purchases a call option with a strike price of $150 on a stock trading at $130. The option is OTM because $130 < $150.
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Put Option: An investor buys a put option with a strike price of $80 on a stock trading at $100. The option is OTM because $100 > $80.
FAQs
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Q: What is the main risk of holding OTM options?
- A: The primary risk is the potential for the option to expire worthless, leading to a total loss of the premium paid.
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Q: Why would investors trade OTM options if they have no intrinsic value?
- A: Investors may trade OTM options to speculate on large price movements or hedge existing positions with lower initial costs compared to ITM options.
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Q: Can OTM options become ITM?
- A: Yes, if the market price of the underlying asset moves favorably relative to the strike price, the OTM option can become ITM.
Related Terms
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In the Money (ITM): Options with intrinsic value (strike price below market price for calls, above for puts).
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At the Money (ATM): Options where the strike price is equal to the market price of the underlying asset.
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Intrinsic Value: The value of an option if exercised immediately (difference between market price and strike price).
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Extrinsic Value: The portion of an option’s price not attributed to intrinsic value, reflecting time value and volatility.
Summary
Out of the Money (OTM) options are those that have no intrinsic value at a given point in time. For call options, this occurs when the strike price is above the market price of the underlying asset. For put options, it occurs when the strike price is below the market price. While these options carry higher risk due to their lack of intrinsic value, they offer opportunities for higher leverage and lower initial costs, making them attractive for speculative and hedging strategies.
References
- Natenberg, S. (1994). Option Volatility and Pricing: Advanced Trading Strategies and Techniques. McGraw-Hill.
- Hull, J. C. (2017). Options, Futures, and Other Derivatives. Pearson Education.
- Chicago Board Options Exchange (CBOE). (2024). Glossary of Options Terms. Retrieved from www.cboe.com.
