Understanding the Concept of Out-of-the-Money (OTM) Options in Finance

Out of the Money is a commonly used phrase in finance, but its meaning goes beyond being accurate or precise. In fact, it has become a popular term in various industries, from share market to business strategy. But what exactly is OTM, and why has it gained widespread usage? This guide will discuss the concept and explore its various applications in different contexts.

What is Out of the Money (OTM)?

An important concept in options trading is being “Out of the Money” (OTM). When an option is considered OTM, it means that the current market price of the underlying asset is not good for exercising the option.

These options can be both call and put options . For a call option to be OTM, the strike price is higher than the current market price of the underlying asset. This means that the investor would incur a loss if the option were exercised at that moment. On the other hand, the strike price is lower than the current market price for a put option.

In this case, exercising the put option would also result in a loss. Understanding the relationship between OTM positions and the strike price is crucial for options traders, as it helps make informed decisions regarding the potential profitability and risks associated with different options.

Out-of-the-Money Options

Out-of-the-money options, whether call options or put options are a crucial aspect of options trading. Unlike In the Money (ITM) options, these options have an unfavorable strike price compared to the underlying asset’s current market price.

This means that if the option were to be exercised immediately, it would result in a loss for the investor. Due to this lack of intrinsic value , they might seem unappealing at first glance. However, they still possess extrinsic value, often called time value. This extrinsic value accounts for factors such as the time remaining until expiration and market expectations. Investors might still consider OTM options for various reasons despite being out of the money.

For instance, they may believe that the underlying asset’s price will move significantly in their favour before the option expires, thus enabling them to profit from the extrinsic value. Further, they tend to have lower upfront costs, making them attractive for those seeking affordable speculative plays or hedging strategies.

Out-of-the-Money Options Example

Suppose a stock is currently trading at Rs. 100, and an investor purchases a call option with a strike price of Rs. 120. Since the strike price is higher than the market price, this call option is considered out of the money. If the stock price remains below Rs. 120 until the option’s expiration, it would not make sense for the investor to exercise the option, as they would incur a loss.

However, if the stock price rises significantly and reaches Rs. 130 before the option expires, the investor could profit from selling the option to another buyer. This is because the option now has some extrinsic value due to the increased likelihood of the stock price surpassing the strike price.

Now, let’s explore an example of an OTM put option. Suppose the same stock is trading at Rs. 100, and an investor purchases a put option with a strike price of Rs. 80. In this case, the strike price is lower than the market price, making the put option out of the money. If the stock price remains above Rs. 80 until the option’s expiration, the investor will not exercise the option, as it would result in a loss.

However, if the stock price declines significantly and falls to Rs. 70 before the option expires, the investor could benefit from selling the put option to another buyer. This is because the option now holds extrinsic value, reflecting the increased probability of the stock price dropping below the strike price.

Why Does it Matter if an Option is OTM?

When discussing option trading, it is crucial to understand the significance of an option being out of the money. An Out of the Money option is one where the strike price is not profitable for immediate exercise, given the current market price of the underlying asset.

While this may initially seem like a disadvantage, it presents unique opportunities for traders and investors to manage their risk and potentially reap rewards. These options are typically less expensive than their in-the-money counterparts, making them attractive for those seeking lower upfront costs and limited risk exposure. Traders can use them as speculative tools, hoping for a promising price movement in the underlying asset.

Note that the likelihood of these options expiring is worthless. Investors may also use OTM options for broader trading strategies, such as hedging or generating income through covered call writing.

OTM Option Characteristics

OTM options possess distinct characteristics that set them apart from other options in the market.

One notable feature is their lower premiums compared to in-the-money and at-the-money options. This lower cost allows traders to enter positions with less upfront capital, making them more accessible to a wider range of investors. However, it is important to acknowledge that the lower premium reflects the higher probability of the option expiring worthless.

Another key characteristic of these options is their higher risk/reward ratio. Due to their out-of-the-money status, they are less likely to be profitable at expiration. However, Out of the Money options can yield substantial returns if the underlying asset experiences a significant price movement in the anticipated direction. This higher potential reward makes them attractive to traders willing to take on greater risk for higher gains.

Furthermore, they are inherently speculative in nature. Traders and investors who engage in OTM option trading are making bets on the future direction of the underlying asset’s price, understanding that their options may expire worthless if the market does not move in their favour. This speculative nature requires a thorough understanding of market trends , analysis, and risk management strategies to mitigate potential losses.

Advantages

• Lower upfront costs: These options are more affordable than in-the-money and at-the-money options, allowing investors to enter positions with less initial capital.

• Higher leverage: Due to the lower premium cost, they offer higher leverage, allowing investors to control a larger amount of the underlying asset with a smaller investment.

• Potential for significant returns: While the probability of profitability at expiration is lower if the market moves favourably, these options can yield substantial returns.

• Flexibility in trading strategies: They provide traders with the opportunity to implement various strategies, such as speculation, hedging, and income generation, based on their market outlook and risk tolerance.

• Diversification: Including them in a portfolio can enhance diversification, as they offer exposure to different price movements and generate profits even in non-directional markets.

Disadvantages

• Higher risk of expiring worthless: These options are more likely to expire out of the money, resulting in a total loss of the premium paid.

• Need for significant market moves to become profitable: They require larger price movements in the underlying asset due to their positioning outside the current market value.

• Decay of time value: As time passes, their value diminishes, especially as expiration approaches. This time decay can erode the option’s value, even if the underlying asset moves in the desired direction.

• Limited profit potential: The potential for significant returns with Out of the Money options is counterbalanced by limited profit potential. The option’s price may only move incrementally, preventing investors from fully capitalising on favourable market movements.

• Higher volatility risks: They are more sensitive to changes in market volatility, which can impact their value significantly. Higher volatility increases the chances of the option expiring worthless or making it more expensive to exit the position.

Difference Between Out of the Money and In the Money

Out of the Money options and In the Money options are two distinct classifications in option trading . The main difference between the two lies in their intrinsic value and risk profile. Let’s compare and contrast these options using a table and discuss their key differences in detail.

Conclusion

Knowing when an option is OTM can help make informed decisions and minimise potential losses. These options may not always be seen as favourable, but they still hold potential for profit in the right circumstances. With a deeper understanding, investors can confidently navigate the market and make strategic moves towards their financial goals.