Out-of-the-money (OTM) is a crucial concept in the realm of options trading, influencing investment strategies and risk management. When an option is deemed ‘out-of-the-money’, it means the option’s current market price is unfavourable for exercise or would result in a loss if executed. Understanding this status is fundamental for options traders seeking to make informed decisions. In this exploration, we’ll delve into its meaning and provide illustrative examples to elucidate its implications in the dynamic landscape of financial markets.
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Defining Out-of-the-Money
An option contract without any intrinsic value is said to be out-of-the-money in the context of options trading.
- Purchase option is another name for an out-of-the-money call option.
- Such options only have temporal value because they transact at lower prices than the value of the underlying asset.
- Options that OTM are those whose strike price for a call exceeds the current value of the underlying securities (or less for a put).
- Two kinds of OTM options are available—call and put options.
Investors should purchase the option when the price on the open market is less than the strike price, but they expect the price to appreciate sharply. Additionally, if the contract is about to expire, the investor can determine if it is advantageous to exercise an option by comparing the cost to the market price.
An Example
Let us take an OTM call option example. Consider a trader who has a 250 ITC January 20 call option, which entitles them to buy ITC stock at ₹250 per share once the contract expires.
- If the stock price is less than ₹250, let’s say at ₹220, this call is termed out-of-the-money.
- Since the stock is now trading for ₹220, there would be no purpose in exercising this option and purchasing it for ₹250.
What is an OTM Put Option?
A sell option is also referred to as a put option. Investors shouldn’t exercise the option when its cost in the open market is greater than the strike price or contract price since doing so would be pointless and unfavourable for the investor.
As in the above example, the holder of a 180 ITC Put on January 20 would not exercise this option. This is because by exercising the contract, they will be entitled to sell ITC shares for ₹180 instead of the stock’s current market price, which you can assume to be ₹220.
Why Use Out-of-the-Money Options?
The following are reasons why traders should definitely try out OTM options.
- In contrast with in-the-money or at-the-money options, it might give a bigger percentage gain for similar price swings in the underlying asset.
- Since it lacks inherent value, its cost (measured in absolute Dollars) is lower than that of an in-the-money or at-the-money option.
- Compared to the money option, the price is less.
- Comparing it to alternative possibilities, it includes calculated risk.
What Happens When an Option Expires Out-of-the-Money?
Which side of the contract you are on will determine whether the trade ends in the red.
- If the option you bought, such as a call or put, expired out-of-the-money, you would lose the premium you paid for it.
- If you are the seller, whether a call or a put option, and it expires out-of-the-money, you will win instead of losing anything.
Do Out-of-the-Money Options Have Value After Expiration?
- Expiration Worthlessness: OTM options commonly expire without intrinsic value.
- Unfavourable Strike Price: An option is considered OTM at expiration when its strike price is not advantageous relative to the current market price of the underlying asset.
- Limited Financial Incentive: Typically, there is no compelling financial reason to exercise OTM options after expiration as they do not offer a profit opportunity.
- Lack of Intrinsic Value: Investors holding OTM options after expiration do not realise intrinsic value from exercising them, as the strike price is not in their favour.
- Premium Costs: The premiums paid for OTM options, representing the cost of the contract, may be lost if the options expire worthless.
- Risk of Loss: Investors need to be mindful of potential losses associated with paying premiums for OTM options that provide no returns upon expiration.
Examples of Out-of-the-Money Options
Many investors engage in speculative trading by utilising out-of-the-money options due to their lower initial costs. In the stock market, opting for out-of-the-money positions is a common strategy for speculators. Let’s explore two examples of out-of-the-money options contracts: a call option and a put option.
A call option is acquired when there is an expectation that the underlying asset’s price will rise, while a put option is purchased if a decline in the underlying price is anticipated. Out-of-the-money options in the stock market can yield significant profits during periods of market volatility.
For a call option to be profitable, the underlying asset’s price must exceed the call option’s strike price. This enables the option holder to exercise the right to buy the asset at the strike price and subsequently sell it in the market at a higher rate, securing an immediate profit. A call option remains out-of-the-money when the underlying asset is trading below the call option’s strike price. Engaging in out-of-the-money options trading in the stock market necessitates careful analysis of market trends.
Conversely, with a put option, the underlying asset’s price must fall below the put option’s strike price for it to become profitable. This empowers the option holder to exercise the right to sell the asset at the strike price, realising a profit based on the initial prediction of the price decline. A put option is considered out-of-the-money if the underlying asset’s market value is higher than the put option’s strike price. For buyers, out-of-the-money options offer the potential for substantial profits if the market makes a significant move in the desired direction. Engaging in out-of-the-money options trading in the stock market demands a solid understanding of market volatility.
Conclusion
Out-of-the-money options occur when the current market price of the underlying asset is unfavorable for the option holder’s profit. A call option is OTM if the asset’s market price is below the option’s strike price, while a put option is OTM when the asset’s market value exceeds the put option’s strike price. Traders often choose OTM options for their lower initial costs, but successful trading requires a precise understanding of market dynamics and accurate price predictions. Whether using call options for upward speculation or put options for downward forecasts, grasping the concept of OTM is crucial for making informed decisions in the options market.
