Last Updated on 3 November, 2022 by Samuelsson
Out of the money (OTM) is one of the key three terms used in the trading of options. A call option is out of the money (OTM) when the strike price is is higher than the market price, and a put option is out of the money if the strike price is lower than the market price. Simply put, out of money means that there is no money left to be made if the price of the security won’t change in favor of the option holder.
So for example, if we have bough call-options that have a strike price of $80, then the option will be out of the money if the price of the stock is lower than $80. Similarly, if we have put option with a strike price of $80 the option will be out of money if the price of the stock is higher than or equal to $80.
So now that we know that OTM is let’s compare it to another important term in options trading, namely “in the money”.
In The Money Vs. Out Of Money (OTM)
Before we can compare in money and out of money, we need to understand what in money really is.
In the Money
When the spot price of the option is less than the spot price of the underlying asset. In simpler words, in the money means that the price of the option is more than the strike price or market price of the underlying asset for a call option, and the other way around for a put option. In the money simply means that there is money left in the options contract or more specifically, that its intrinsic value is positive.
In such a situation the holder of the option has the right to purchase the underlying security at a price lower than the current market price. This right has a value when you can purchase the option at a price lower than the current market value. The difference between these values is known as the before mentioned intrinsic value of the option.
Understanding The Difference Between OTM And ITM
In the money and out of the money are tow concepts of moneyness that is often used in trading to define the intrinsic value of the option. The main difference between out of money and in the money is the difference between the strike price and the intrinsic price of the underlying asset. This discrepancy in both values is the moneyness function of the option.
To make it clearer, in the money means that the option has a positive intrinsic value, while out of the money means that its intrinsic value is negative.
An ITM is more favorable for the holder since it means that the option holder, as it looks for the moment, will profit from exercising the option. However, an OTM that for the moment has a negative intrinsic value could very well produce a profit if the market moves in your favor. However, with ITM the price fluctuations are generally lower. The reason for this is that in ITM the underlying asset has intrinsic value which is not present in the case of OTM. ITM options are more expensive than OTM options also due to this reason.
Can You Exercise An Out Of Money Option?
An ordinary investor who buys the option on the basis of speculation would never exercise the right of out of the money (OTM). This is not favorable for the buyer as the intrinsic value is lower than the strike price or even negative. We can see this from the perspective of a professional trader then there are times when the trader does actually exercises this right at the expiration of the option.
The answer is that you can exercise an out of the money option. The basic motive for this is to minimize or ideally remove the risk factor and save the investor or trader from a total loss. For example, it could be that you failed to get out of a position on Friday afternoon, in which you also happen to own an options contract that expires that day. Even if the options contract is marginally OTM you might consider to exercise it, since you do not want to take the risk of losing money in the event of a massive opening gap on Monday.
When To Use Out Of Money Option?
As discussed earlier, out of option is a method that is used to prevent or limit the possible losses in a trade. You don’t have to exercise this option if you are about to sale the options in the market. Before exercising this option, you need to asses a few things about the company to make sure that you are taking the right decision.
1) Compare The Stock Price With The Strike Price Of The Option: Only of the call option is in money, you would buy and exercise your rights. To understand this let’s take a simple example. If a stock has a strike price of $20 and the price of the stock is $15m using out of money option is not a wise decision. Because the stock can be bought at a price less than the strike price.
2) Take a close look on company’s fundamentals such as the growth of its earnings: Before exercising this right, it is wise to take a view of the important statistics of the company and the consistency of its cash flow. In order to make any decision, you should take a close view of all the information so that you can make an informed decision. If the basic figures of the company are sound and growing, then you can wait and hold on to the shares for a long run to earn capital gains.
3) Compare the possible profits that you may earn in both cases: Compare the gains that you may get in case you hold on to your options or exercise the out of money option. Outweigh the pros and cons of both choices to see what can be the possible outcomes in both situations.
Why Do Out Of Money (OTM) Options Cost Less?
Buying out of money options can be risky but sometimes profitable as well. But this needs to be done with great deliberation and careful assessment of the probability of making against other strategies being used. The option continues to become cheaper as the option moves more towards the out of money point. The difference between the strike price increases and it is less likely for the option to come closer to its strike price. Also, the cost of the Out of the money options will be less which are closer to their expiration owing to the less remaining amount of time it has in order to reach close to the strike price. Another great reason for the less cost of out of money options is due to the fact their intrinsic value is zero or negative.
Positive Aspect Of Out Of Money(OTM) Options
One can achieve greater leverage prospects with out-of-money options than by using in the money ones. An out of money option becomes an in the money option if the underlying stock does not move towards the speculated direction. Ultimately the price will increase on a higher percentage compared to if the trader would have initially bought an in the money option. Resultantly this combination of higher leverage prospects and lower cost is quite the reason why risk taking traders prefer to buy out-of-money stock over in the money or at the money ones. But beefier making the final decision, a trader has to outweigh the tradeoffs of both the strategies.
What Is Better To Use, Out Of Money (OTM) Option Or In The Money?
It is quite evident that using in the money move is a smart option that you can use while trading. In a balanced portfolio, options should be placed to keep it easier for the traders to limit their losses and hedge their risks while getting a chance to earn more in the markets. The stock options allow the trader or investor to be able to buy the stock at a specifically stated price and the relationship between the current market price and the strike price is what determines the value of the option.
When a trader or investor has purchased the stock for a shorter period, nothing is better than to keep options at hand to handle any calculated or unforeseen situations.
Only in situations where you are left with almost no options, you should use the out-of-money option as it offers you a lower price. Out of the money, options are more cheaply valued than at the moment or in the money options. Mainly because in order for the underlying value of the asset to increase, this value should move further.