Options traders typically want their option contract to be “in the money,” meaning the contract has greater value than buying or selling based on current market values. But depending on your risk tolerance, you may want to use out-of-the-money (OTM) options as part of your investment strategy.
Here’s how OTM contracts work and how they can strengthen your portfolio.
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Understanding “Out of the Money”
You remember how an option contract works, right? These contracts give you the right to buy or sell an asset at a particular price, known as the strike price. The idea is simple: if your strike price is in your favor, your option contract has intrinsic value, or is “in the money.”
But it’s also possible that the asset's market price is preferable to the price in your contract. When this happens, your contract is said to be “out of the money” (OTM) — it lacks intrinsic value but still holds extrinsic value.
Trading Options in This Style
Options contracts can flow in two basic directions. Here’s how OTM contracts work in each type of contract.
1. Call Options
A call option grants you the right to purchase an asset at the strike price listed in your contract. But if the strike price is higher than the current market price, your contract becomes over a specified period of time an OTM option, meaning your contract doesn’t offer a better deal than the market over a specified period of time.
2. Put Options
A put option grants you the right to sell an asset at the strike price listed in your contract. But your contract can become OTM if the stock price falls below your strike price, which over a specified period of time means you’d lose money if you exercised your option, again indicating that your contract over a specified period of time lacks intrinsic value.
Out of the Money vs. In the Money
By now, it should be clear that OTM options differ significantly from in-the-money (ITM) options. In-the-money options hold intrinsic value; by exercising your option, you stand the strongest chance of generating a return, though trade commissions can vary between brokers.
OTM options have no intrinsic value. In fact, if you were to exercise the option, you’d lose money compared to buying/selling an asset according to its current market price.
What Happens When an Option Expires OTM?
If an OTM contract expires, it becomes worthless. This means you’ll lose the right to exercise the contract. You’ll also lose any premiums you paid in obtaining the contract.
Do OTM Options Have Value, or Are They Worthless?
An OTM option lacks this intrinsic value, but OTM options may still carry extrinsic value. This means an OTM contract might be valued based on whether market prices will shift before the contract expires.
For instance, an OTM contract with one month remaining until its expiration date will have more value than an OTM contract with only a week until its expiration.
How Does the Moneyness of an Option Affect Its Premium?
Another way of defining in-the-money/out-of-the-money options is by evaluating their respective deltas. A delta is used to measure risk and estimates how much a contract might change in value based on a $1 change in the underlying security.
OTM contracts have deltas below 0.5 in value, while ITM contracts have deltas above 0.5. As a general rule, the higher the delta, the higher the contract premium and the higher the risk.
OTM Options Example
Imagine that you want to purchase an OTM contract as part of an aggressive options strategy.
You start by purchasing a call option for Company X with a strike price of $25. Currently, Company X is trading at $15 per share, so the contract can be said to be out of the money.
Now, you play the waiting game. Before long, the price of Company X rises to $35 per share. You’re now free to exercise your contract. By doing so, you’ll gain a gross profit of $10 per share ($35-$25), and because your fees are minimal, you’ll keep more of these profits for yourself or sell the option itself.
Advantages of OTM
Why might you consider an OTM options trade? There are actually several advantages:
- OTM options cost less, increasing your profit margin.
- OTM options have lower risk because of their lower cost.
- OTM options may have extrinsic value depending on their expiration date.
These advantages mean that traders should not only focus on ITM options but also consider the costs/benefits of OTM contracts.
Limitations of OTM
OTM contracts aren’t without drawbacks. For example:
- They may expire worthless.
- They offer lower liquidity because of a lack of intrinsic value.
- It’s harder to predict when OTM will become ITM.
Consequently, investors can lose money on an OTM option if it expires without changing value.
A Plan for Every Financial Goal
What are your financial goals? To save for retirement? Refinance your house? Stock trading can help you build wealth for your future, and OTM options trading is one of several strategies that can help you get there.
Frequently Asked Questions
Why would anyone buy an option that is out of the money?
Some traders purchase out-of-the-money options because the price is low, and they hope the contract will gain value before its expiration date.
Is out of the money in options good?
Technically, no, though some traders purchase OTM contracts hoping that prices will shift in their favor before the contract expires.
Is it better to buy ITM or OTM options?
It depends on your level of experience and your risk tolerance. ITM options are generally lower risk and regarded as the safer option, though OTM options still offer the potential for gains.
About Sarah Edwards
Sarah Edwards is a finance writer passionate about helping people learn more about what’s needed to achieve their financial goals. She has nearly a decade of writing experience focused on budgeting, investment strategies, retirement and industry trends. Her work has been published on NerdWallet and FinImpact.