"Out of the Money" (OTM) is a term predominantly used in the world of finance and trading, specifically when dealing with options contracts. To fully grasp this concept, we need to delve into both the mechanics of options and the implications of an option being classified as OTM.

Key Definitions

What Does Out of the Money Mean?

An option is considered OTM if it holds no intrinsic value, possessing only extrinsic value. The criteria for determining whether a call or put option is OTM are straightforward:

Example

Imagine a stock trading at $10. A call option with a strike price of $12 would be out of the money, as the market price is lower than the strike price. Conversely, a put option with a strike price of $8 is also OTM since the market price exceeds the strike price.

The Difference Between OTM, ITM, and ATM Options

To provide perspective, an ITM option has favorable exercising potential, while OTM options, like those with large strike price differences from the underlying, may not provide immediate exercising benefit but can still retain value due to their extrinsic nature.

Why Traders Use OTM Options

While OTM options may seem less appealing due to their lack of intrinsic value, they do have advantages:

  1. Lower Premium Costs: These options are typically cheaper than their ITM or ATM counterparts, making them attractive for speculative traders looking to leverage small movements in the underlying asset.

  2. High Leverage Potential: OTM options can provide significant returns if the underlying asset experiences a movement that favors the option, amplifying a trader’s profit potential.

  3. Possible Profit Through Sale: Even if an option remains OTM, it may still be sold for a premium that exceeds the initial purchase price before expiration.

The Risk of OTM Options

However, there are notable risks:

  1. Expiration Worthlessness: At expiration, if an option remains OTM, it expires worthless, and the investor loses the entire premium paid.

  2. Time Decay Impact: As the expiration date approaches, the extrinsic value of OTM options diminishes, especially if there is insufficient movement in the underlying asset's price.

  3. Volatility Changes: Fluctuations in market volatility can skew the expected movement of the underlying asset, impacting the viability of OTM options.

What Happens at Expiration?

As reiterated, if an option is out of the money at expiration, it will become worthless. This occurs because exercising an option that does not have favorable terms would not make sense mathematically for the holder. The only way an OTM option retains value leading up to expiration is through its extrinsic component, which makes sense if the underlying asset has the potential to reach favorable prices.

Conclusion

Out of the money options are an integral part of options trading strategy. While they pose specific risks, including potential loss of the premium if they remain OTM at expiration, they also present opportunities for traders – notably their lower purchase costs and higher leverage potentials. Understanding these dynamics equips traders with the knowledge necessary to make informed decisions in their investing strategies. By carefully evaluating market conditions, trader sentiment, and the time to expiration, investors can effectively utilize OTM options as part of a comprehensive trading strategy.