In short:
Out-of-the-money (OTM) is a term used to refer to options whose value is entirely extrinsic. That is, the price of the underlying asset is far away from the options strike price in an unprofitable direction for the option owner.
For example, an OTM call option will have a higher strike price than the price of the underlying asset. Conversely, an OTM put option will have a lower strike price than the price of the underlying asset.
Alternative terms to describe the moneyness of an options contract are in the money (ITM) and at the money (ATM).
Key Points
- Out-of-the-money (OTM) refers to options whose value is entirely made up of extrinsic value.
- OTM options are not in a position to be profitably executed, therefore, buyers of OTM options are buying the time value of the option.
- An OTM call option will have a higher strike price than the price of the underlying asset.
- An OTM put option will have a lower strike price than the price of the underlying asset.
In-depth:
Understanding Out of the Money (OTM)
Out-of-the-money (OTM) refers to an options contract where the difference between the strike price and the price of the underlying asset does not benefit the owner of the option.
For example, say we are looking at a Microsoft (MSFT) 295 call option and the current price of MSFT is $289/share, this option would be deemed to be OTM. This is because the strike price of the call option is significantly above the price of the underlying asset (MSFT stock).
What makes the option OTM is that the MSFT call option is not in a position to be profitable as it has no intrinsic value. Since a call option gives the buyer the right but not the obligation to buy the underlying stock at the strike price, with the strike higher than the underlying price there is no gain to be had by exercising the option.
The only value of an OTM option is the value of the time remaining before the options contract expires. The more time until expiration, the more valuable the option as there is more time for the option to end up ITM.
Additionally, the further OTM an option is the less valuable it is as it is less likely to end up ITM.
Investors may buy OTM for a variety of different reasons including hedging and speculation. If an investor is looking to speculate with OTM options, they are likely betting on a low probability/low cost but high return strategy. That way, if they are wrong, they only lose a small amount but if they are right they win by a lot.
For hedging, an investor with either a short or long position may elect to use OTM options to reduce the risk of large losses on positions they feel have a possibility to move radically against them. By using an OTM option, the investor can define the maximum amount they could lose for a much lower price than by using an ATM or ITM option.
Out Of The Money (OTM) vs In The Money (ITM)
So, what’s the difference between out-of-the-money (OTM) options and at-the-money (ITM) options?
ITM options have immediate value, called intrinsic value. This means the owner of the option could immediately exercise the option and realize a gain (not necessarily profit) from the difference between the strike and underlying assets price. An OTM option on the other hand has no immediate exercisable value. Instead, the only value an OTM option has is time value or the time remaining until the option expires.
Out Of The Money (OTM) vs At The Money (ATM)
So, what’s the difference between out-of-the-money (OTM) options and at-the-money (ATM) options?
OTM options and ATM options are more similar than ITM options. This is because both OTM and ATM options value is composed entirely of time value. Neither OTM or ATM options can be exercised yet to the benefit of the option owner. The main reason ATM options will trade higher than similar OTM options is because ATM options have a higher likelihood of ending up ITM than OTM options.