Understanding Out Of The Money Option Strategy

B y this point in your investment career, you’ve probably heard the phrase ‘out of the money’ before. If you’re a beginner and haven’t heard the term yet, then it’s only a matter of time until you do. Out of the money describes options that only contain an extrinsic value. Simply put, out-of-the-money (OTM) options are cheaper than in-the-money (ITM) and at-the-money (ATM) options because they require movement for their value to increase.

Investors should consider whether an OTM option is a good strategy for their investments before diving in and making a move using out of the money. It’s essential to understand what out-of-the-money options are, the differences between options, what happens when an option expires while out of the money, and the advantages and disadvantages of purchasing these options.

Key Takeaways

  • Options can be out of the money, at the money, or in the money.
  • Out-of-the-money options are cheaper to purchase than both in-the-money and at-the-money options.
  • Out-of-the-money and at-the-money options both lack intrinsic value.
    • This lack of intrinsic value can be advantageous for investors. Because there is a smaller initial investment, you have a greater chance for substantial profit if the stock moves in your favor.
  • OTM options are desirable for traders who don’t have a lot of capital for an initial investment.
  • ITM and ATM options are priced higher than OTM options and have smaller price move percentages overall.

What Does Out of the Money Mean?

When an option is out of the money, it means that option has no intrinsic value. OTM options are great for traders who don’t have a lot of capital to invest but still want to keep their portfolio active. An out-of-the-money option is cheaper to purchase than an in-the-money option and can gain value quickly if the underlying stock goes above the strike price.

A strike price that’s lower than the current price of the underlying security is an out-of-the-money put option. Another OTM option is when a put option has a higher current underlying security price than the strike price. A buyer in this situation would not exercise their right to sell since they would be receiving less than the option’s current value. A call option is considered out of the money if its current price is lower than the strike price.

These types of options have less than 50.0 delta. Keep in mind that just because an option is cheap doesn’t mean you should buy it. Understanding the underlying risk is vital in an OTM situation.

An out-of-the-money option depends significantly on time value. The more time you have until that option expires, the greater the time value it has. With a longer time frame, there’s a higher chance that the option, at some point, will become in the money during this time frame and before its expiration date. If this happens, then the option gains intrinsic value.

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Key Differences Between Options

There are several critical differences between out of the money, in the money, and at the money when it comes to options trading. Before delving into the pros and cons of OTM options, it’s important to understand the differences between ITM, OTM, and ATM options. Here are some fundamental differences between them:

  • ITM options have intrinsic value and are priced higher than out-of-the-money options. Their price changes are generally smaller than an OTM option.
    • An in-the-money call option allows the investor to buy below the current market value.
    • An in-the-money put option allows the investor to sell above the current market value.
  • OTM options have no intrinsic value, only extrinsic value.
    • An out-of-the-money call option offers the underlying price below the strike price.
    • An out-of-the-money put option offers the underlying price above the strike price.
  • ATM options also have no intrinsic value, only extrinsic, and are usually priced higher than out-of-the-money options.
    • At-the-money options are purchased when the underlying price and the strike price are identical.

No option purchase ever guarantees that the investor will make a profit. Other considerations include the premiums, or fees, associated with purchasing options. The premium will affect the overall profitability of any transaction.

Examples of Out-of-the-Money Options

Let’s consider a few examples of out-of-the-money options used as an investment strategy. If you have a stock that’s trading at $80, you can purchase an OTM option for $82 if you think the price will rise above that $82 mark. Another example of an OTM option is if the strike price is at $7 and the underlying stock is currently trading at $6, then it’s out of the money. The lower that $6 gets, the more out of the money it is.

Before that option expires, the price increases to a point where it’s in the money. It’s now worth it to exercise the right to buy and make a profit. If an option was purchased for $7 and is now worth $9, then there’s a $2 profit, or advantage.

What Happens If Your Option Expires Out of the Money?

What happens if you’re the owner of an option that expires while out of the money? In this scenario, you lose the amount of premium you have invested in that specific option. You no longer have any right in that underlying security. That’s why it’s essential to be confident in your knowledge of these options and have a good understanding of the underlying stock.

If you believe you have the correct information on the stock and think that it could end up making a significant upward move, then buying an out-of-the-money call option could bring in a fair amount of profit. Understanding the trends and movement of any specific stock that you’re considering could help save you from losing your entire premium.

Every trader will have moments where they incur a loss, whether it be a significant loss or only the premium you have paid. Don’t let this discourage you from continuing to invest and building a diversified portfolio.

Advantages and Disadvantages of OTM Options

OTM options can be an aggressive form of trading since there’s a greater potential of loss, as with any investment. However, there are some advantages to consider when purchasing these contracts, so don’t count them out just yet:

  • OTM options offer a higher percentage gain over ITM options.
  • OTM options are cheap to purchase, which is especially attractive to beginning investors.

While there are advantages of OTM options, there are also some disadvantages to be aware of:

  • OTM options require a significant understanding of the underlying stock.
  • OTM stock that expires worthless means that you lose all of your money on that stock.

The potential for loss is more significant than if you were to purchase an ITM option. However, you may also have some significant leverage if the stocks were to move in your favor since you have a low initial cost investment.

A s with any strategy associated with investing in the stock market, knowledge is key. After you have a better understanding of the risks involved with out-of-the-money options, you may find times when you feel the investment is worth the risk. This short-term trading option offers a quick-moving, exciting trade where you may be able to predict your profits or losses before it happens. If your stock moves in the right direction and ends up being in the money at expiration, you could be looking at a significant profit.

With the right knowledge, investors can access a variety of trading options to get the most out of their investment portfolio. There will be times when an in-the-money, at-the-money, or out-of-the-money option will be attractive to maximize the profitability of certain stocks. Research and education will significantly assist any investor in utilizing a variety of strategies. Remember, there’s no such thing as knowing too much about investing, so keep watching for new information to help you become a better trader.