Out-of-the-Money (OTM) describes a situation in which an option’s strike price is not favorable relative to the current market price of the underlying asset. Therefore, the option holds no intrinsic value but has extrinsic or time value.
Types of OTM Options
Call Options
- Definition: A call option is considered OTM when the strike price is higher than the current market price of the underlying asset.
- Example: If a stock is trading at $50, a call option with a strike price of $60 is OTM.
Put Options
- Definition: A put option is OTM when the strike price is lower than the current market price of the underlying asset.
- Example: If a stock is trading at $50, a put option with a strike price of $40 is OTM.
Special Considerations
Time Value
OTM options consist solely of time value since they lack intrinsic value. The time value is influenced by the remaining time until expiration and the volatility of the underlying asset.
Volatility Impact
As volatility increases, the extrinsic value of an OTM option also increases, making OTM options more attractive to traders who speculate on price movement.
Risk and Reward
OTM options tend to be cheaper than In-the-Money (ITM) or At-the-Money (ATM) options but offer a higher percentage return potential due to their lower initial cost and higher leverage.
Examples
- Stock Example: If Stock X is trading at $100, a call option with a strike price of $120 is OTM because the option provides no intrinsic value.
- Index Option Example: For an index trading at 2000 points, a put option with a strike price of 1800 is OTM since the index level is above the strike price.
Historical Context
The concept of options and defining them as OTM has origins in early financial markets where derivatives trading began to offer more sophisticated investment strategies. The well-developed options market we see today stems from the establishment of formal exchanges such as the Chicago Board Options Exchange (CBOE) in 1973.
Applicability
OTM options are widely used by investors and traders for speculative purposes, hedging strategies, and leveraged investment positions. They are popular in volatile markets where price swings can turn OTM options profitable in a short span.
Comparisons
- OTM vs. ITM Options: ITM options have intrinsic value and are more expensive but less risky compared to OTM options, which are cheaper but riskier.
- OTM vs. ATM Options: ATM options have strike prices close to the current market price, often carrying a balanced mix of intrinsic and extrinsic value.
Related Terms
- In-the-Money (ITM): Options with strike prices favorable relative to the market price of the underlying asset.
- At-the-Money (ATM): Options with strike prices approximately equal to the market price of the underlying asset.
- Intrinsic Value: The inherent value an option would have if exercised at the moment.
- Extrinsic Value: The value attributed to the time left until expiration and the volatility of the underlying asset.
Frequently Asked Questions (FAQs)
Why would an investor buy OTM options?
Investors buy OTM options to speculate on large movements in the price of the underlying asset, which can lead to significant returns due to the high leverage involved.
Do OTM options always expire worthless?
Not necessarily. If the underlying asset’s price moves favorably past the strike price before expiration, an OTM option can become ATM or ITM and gain value.
How do OTM options benefit traders?
OTM options allow traders to take position with lower capital investment and potentially yield higher percentage returns if the market moves significantly in the desired direction.
References
- Hull, J. (2018) “Options, Futures, and Other Derivatives”.
- McMillan, L. (2012) “Options as a Strategic Investment”.
Summary
Out-of-the-Money (OTM) options represent a unique financial instrument characterized by strike prices that are not favorable compared to the current price of the underlying asset. Despite lacking intrinsic value, they serve essential roles in speculative and hedging strategies, offering high leverage and potential for substantial returns.
