Out Of The Money Options

This term along with the terms In-the-Money and At-the-Money are used to describe the relationship between an option’s strike price and the price of its underlying security.  It is important for the option trader to understand these terms in order to assess the potential risks and rewards of any particular option.

When is a call option out-of-the-money?

A call option is out-of-the-money when the option’s strike price is greater than the current price of the underlying security.  This differs from an in-the-money call option, which has a strike price that is less than the current price of the underlying security.  Of course, an at-the-money call option’s strike price is equal to the underlying security’s current price.

The following table illustrates when a call option is out-of-the-money, at-the-money, and in-the-money.  Assume that Hewlett Packard (HPQ) stock is trading at $50 per share.

What happens when a call option expires out-of-the-money?

When a call option expires out-of-the-money, it is entirely worthless.  It has no intrinsic value, and its time value is completely exhausted.  Therefore, the entire premium paid for that option is lost forever.

In addition, out-of-the-money call options are not automatically exercised at expiration.  If they were exercised, the owner of the option would have to purchase the underlying security at the option’s higher strike price instead of the lower current market price.

When is a put option out-of-the-money?

A put option is out-of-the-money when the option’s strike price is less than the price of the underlying security.  Notice that this situation is the opposite of the call option.  An in-the-money put option has a strike price that is greater than the price of the underlying security.  A put option is at-the-money when its strike price is equal to the price of the underlying security.

The following table illustrates when a put option is out-of-the-money, at-the-money, and in-the-money.  Assume that Microsoft (MSFT) stock is trading at $50 per share.

What happens when a put option expires out-of-the-money?

When a put option expires out-of-the-money, it is entirely worthless.  It has no intrinsic value, and its time value is completely exhausted.  Therefore, the entire premium paid for that option is lost forever.

In addition, out-of-the-money call options are not automatically exercised at expiration.  If they were exercised, the owner of the option would have to purchase the underlying security at the option’s higher strike price instead of the lower current market price.

How is intrinsic value and time value premium calculated for out-of-the-money options?

An option has intrinsic value only if it is in-the-money.  Intrinsic value is the value of an option if it were to expire immediately with the underlying security at its current price.  Out-of-the-money call and put options are always worthless at expiration, and therefore, they never have any intrinsic value.

OTM Option’s Intrinsic Value is always zero

Out-of-the-money call and put option premiums are comprised entirely of time value premium.  Time value premium is the amount by which an option’s total premium exceeds its intrinsic value.  As discussed in the preceding paragraph, out-of-the-money option premiums do not have any intrinsic value.  Therefore, the time value premium for an out-of-the-money option will always be equal to the option’s total premium.

OTM Option Time Value Premium = Total Premium

What are the advantages of trading out-of-the-money options?

One advantage of trading out-of-the-money options is that their premiums are much less expensive in absolute dollar terms than premiums for at-the-money and in-the-money options.  This feature of out-of-the-money options is attractive to option traders who want to establish a position in a particular option series with the least amount of money actually committed.  Take a look at the following table for an illustration of this concept.  Assume that Exxon Mobile (XOM) is trading at $85 per share.

Option Description              Stock Price            Strike Price           Option Premium                  Cost per Contract

XOM July 75 call (ITM)        85                           75                                           12                           $12 x 100 shares = $1,200

XOM July 85 call (ATM)       85                           85                                           6                              $6 x 100 shares = $600

XOM July 95 call (OTM)      85                           95                                           2                              $2 x 100 shares = $200

As you can see, the out-of-the-money XOM July 95 call option is significantly less expensive at  $200 per contract than both the at-the-money XOM July 85 call at $600 per contract and the in-the-money XOM July 75 call at $1,200 per contract.

The most important advantage of trading out-of-the-money options is that they offer significantly higher percentage gains than at-the-money and in-the-money options from the same price movement in the underlying security.  Aggressive options traders who are willing to accept a greater risk of loss look to achieve high percentage gains from out-of-the-money options.

The following table illustrates this concept.  Assume that Exxon Mobile (XOM) is trading at $85 per share when the options below are purchased and then increases to $115 at expiration.

Option Description              Strike Price           Option Premium  Cost per Contract                 Gain at Expiration

XOM July 75 call (ITM)        75                                           12           12 x 100 = $1,200                               115 -75 /12 = 333%

XOM July 85 call (ATM)       85                                           6              6 x 100 = $600                     115-85/6 = 500%

XOM July 95 call (OTM)      95                                           2              2 x 100 = $200                     115-95/2 = 1000%

As you can see, the out-of-the-money XOM July 95 call option would have provided a significantly higher gain of 1000% compared to 500% for the at-the-money XOM July 85 call and 233% for the in-the-money XOM July 75 call.

What are the disadvantages of trading out-of-the-money options?

The most significant disadvantage of trading out-of-the-money options is that they are worthless at expiration.  When an option expires in-the-money, the option retains some intrinsic value that can be converted to cash or used to purchase the underlying security.  Options that expire out-of-the-money have no such intrinsic value and therefore are worth zero at expiration.

Another disadvantage of trading out-of-the-money options is that they pose a higher risk of loss than at-the-money and in-the-money options.  The price of the underlying security will have to move much further in the desired direction for an out-of-the-money option to become profitable compared to an at-the-money or in-the-money option on the same underlying security.  The following table illustrates this concept.  Assume that Wal-Mart (WMT) is trading at $50 per share.

As you can see, the out-of-the-money call option requires an increase in WMT greater than $6 in order to become profitable while the at-the-money and in-the-money call options require increases of just $3 and $1 respectively.  Because the at-the-money and in-the-money calls require a smaller increase in WMT, they are more likely to produce a profit than the out-of-the-money call.

Category: Options Trading Basics