• Skip to primary navigation
  • Skip to main content
  • Skip to primary sidebar

Epsilon Options

Options Trading Education

  • Home
  • How Options Work
    • Puts and Calls Explained
    • Learn Options Trading
    • LEAP Options Explained
    • Put Call Parity
    • Buy to Open vs Buy to Close
    • Volatility Skewness | IV Skew In Options
  • Options Greeks
    • Delta
    • Vega
    • Gamma
    • Theta
    • Rho
  • Options Spreads
    • Long Call
    • Bear Put Spread
    • Iron Condor
    • Bull Call Spread
    • Covered Calls
    • Calendar Spread
    • Backspread
    • Strangle
    • Butterfly
    • Protective Put
    • Straddle
  • Options Brokers Reviews
  • Blog
  • Show Search
Hide Search

Out Of The Money (OTM) Options Explained

Out of the money (OTM) options: where the exercise price for a call is more than the current underlying security’s price (or less for a put).

This is an example of ‘moneyness’ – a concept which considers the strike price of an option in relation to the current stock price.

Let’s look at a couple of examples:


Table of Contents

  • Out Of The Money Call Option
  • Out Of The Money Put Option
  • Intrinsic Value: OTM Options
  • Extrinsic Value Of Out-Of-The-Money Options
    • Extrinsic Value Example
    • Optionality & Option Valuation
  • Behaviour Of OTM Options On Expiry
  • Conclusion & Summary

Out Of The Money Call Option

out of the money call option

Suppose a trader owns a 140 IBM Call Dec 20 call option allowing them to buy IBM stock at $140/share anytime between now and Dec 2020.

This call is said to be out of the money if the stock is less than $140, at $134 say.

There would be no point exercising this option, and buying the stock at $140, as it is available on the market for $134.


Out Of The Money Put Option

out of the money put option

Likewise the owner of a 130 IBM Put Dec 20, allowing them to sell IBM stock for $130 anytime between now and Dec 2020, would not exercise this option as they could get a better price, $134, in the open market.

Hence the put is out of the money too.


Intrinsic Value: OTM Options

Out of the money options have no intrinsic value (unlike in ITM Options).

A call’s intrinsic value is defined as the discount to the stock price enjoyed by the owner of these options. As, by definition, there is no such discount (out-of-the money calls’ strike price is higher than the stock price) there is no intrinsic value.

Similarly the intrinsic value of a put, any premium of exercise price over the stock price, is zero too.

(Intrinsic value cannot be negative).


Extrinsic Value Of Out-Of-The-Money Options

Extrinsic value is defined as the option price less intrinsic value. As an OTM option has no intrinsic value (see above) all its value is extrinsic.

Options beginners struggle with this. Why, they ask, does an option that is, say, $6 out of the money (such as the 140 Dec 20 call above) have any value if a buyer could just buy the stock for a lower price. Wouldn’t the fair value of an OTM option be zero?

Extrinsic Value Example

Well, again looking at above call example, what the owner of the option is buying is the chance that it will move to be in the money (ie above $140) sometime between now and Dec 2020.

Suppose the stock price rose to $150 at expiry (for simplicity). The option holder would profit by $10 – they could exercise their $140 option and sell at $150. Indeed their upside is unlimited – the stock could be even higher.

Their downside is zero (excluding the cost of the option) however. No loss would be made If the underlying stayed below $140 as there is no obligation to exercise the option.

Optionality & Option Valuation

This ability to enjoy unlimited upside but no downside has a value – the call’s so called ‘optionality’. This value is what powers an OTM option’s price.

But how to quantify this value? How would we price the 140 Call, with the stock at $134? That’s for the market to price. But in general its value is mainly determined by:

–              The amount it is out of the money: you’d pay less for a 150 call, $16 out of the money, than the closer to the money $140 call for example.

–              How volatile the stock is. The IBM share price is likely to be much steadier than, say, a start-up. Hence it is much less likely to jump up to the $140 before Dec 2020. Therefore the IBM call option is likely to be worth less. The market’s view of a stock’s future volatility is called implied volatility. 

–              How long to expiry. If there is a long time between now and the option expiration date then it is more likely to cross $140. Therefore, all other things being equal, it is more valuable than a shorter dated option.

(There more on how options work here)


Behaviour Of OTM Options On Expiry

Following on from the last point above, the option has no extrinsic value if there is no time left to expiry as there is no optionality (the stock can never rise to be in the money).

Because it has no intrinsic value either (see above) OTM options expire worthless on expiry.

This makes sense. If the above option, for example, expires with the stock price below $140, the option holder will be able to buy stock at $140.

But they can buy it for less, $134, on the market and so the option has no value to him/her.

An option will expire worthless if it is out of the money as (per the above examples). The market will provide a better price for both buying (call) and selling (put options).

Conclusion & Summary

Out of the money call/put options are those that are above/below the strike price and have no intrinsic value.

They do have extrinsic value – caused by a holder potentially making money if the stock moves.

The market’s view of the stock’s future volatility (ie its implied volatility), how far the strike price is from the stock price and time to expiry are the main factors that influence an option’s market price.

If an option expires out of the money it is worthless.

facebookShare on Facebook
TwitterTweet
PinterestSave

Further Reading On Options Trading...

Puts and Calls: Stock Options Explained

What Are Puts and Calls? We've seen before exactly what options are, how they work and their function. Here we go further and explore the two main flavour of options ...
Read More

Calendar Spread

The Calendar Spreads Options Strategy What is a Calendar Spread? Intro Calendar Spreads are one of the key non-directional strategies used by options traders to make money in any market ...
Read More

How To Learn Stock Options Trading: Stock Options For ‘Dummies’

Would you like to learn stock options trading but don't know where to start? Well we've got your back and designed this step by step guide on how to educate ...
Read More

Options Trading Education

Options trading is a potential lucrative sideline for those willing to put in the effort. Epsilon Options is here to help you learn the skills you’ll need to become a ...
Read More

Options Brokers Reviews

How To Choose The Best Options Broker There are several things an option trader needs to look for in an options broker. However, whilst most traders will need most, if ...
Read More

Options Greeks: Theta, Gamma, Delta, Vega And Rho

The options greeks - Theta, Vega, Delta, Gamma and Rho - measure option price sensitivity to changes in time, volatility, stock price and other parameters. In the world of finance, ...
Read More

Options Gamma Explained: Delta Sensitivity To Price

Gamma is the options greek measuring the sensitivity of delta to changes in stock price. Option traders tend to find it relatively easy to understand how the first-order Greek metrics ...
Read More

Call Option Payoff

A call option payoff depends on stock price: a long call is profitable above the breakeven point (strike price plus option premium). The opposite is the case for a short ...
Read More

Options Theta Explained: Price Sensitivity To Time

Options theta measures option price sensitivity to time. Time Decay & Options Theta All things being equal options lose value over time - so called 'time decay' - and theta ...
Read More

Options Trading Strategy: Long Call

A long call option strategy is the purchase of a call option in the expectation of the underlying stock rising. It is delta and theta positive. Introduction Options can provide ...
Read More

Options Vega Explained: Price Sensitivity To Volatility

Options Vega is the measure of an option’s price sensitivity to changes in volatility. It is the expected change in options price with a 1 point change in implied volatility ...
Read More

Options Rho: Sensitivity To Interest Rates

Rho is the sensitivity of an options's price to changes in interest rates. It is usually only worth considering for long dated options such as LEAPS. Rho is the least ...
Read More

Implied Volatility

What Is Implied Volatility? Implied volatility (IV) is one of the most important concepts in options trading. Unfortunately it’s also one of the most complex. Therefore, let’s build up the ...
Read More

Strangle Spread: A Guide To This Options Trading Strategy

The Strangle Spread Options Trading Strategy Introduction Options, and combination trades such as the strangle spread, can be a very useful tool for both novice and seasoned traders and investors ...
Read More

Out Of The Money (OTM) Options Explained

Out of the money (OTM) options: where the exercise price for a call is more than the current underlying security’s price (or less for a put). This is an example ...
Read More

Primary Sidebar

Featured Posts:

Options Spreads: Put & Call Combination Strategies

Protective Put: This Defensive Put Option Strategy Explained

Options Greeks: Theta, Gamma, Delta, Vega And Rho

How To Learn Stock Options Trading: Stock Options For ‘Dummies’

LEAP Options Explained: What Are They And How Do They Work?

Options Trading Strategy: Butterfly Spread

Copyright © 2022 · Monochrome Pro on Genesis Framework · WordPress · Log in

  • Facebook
  • Twitter
  • Pinterest
  • Privacy Policy