Out-Of-The-Money Call

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

Out Of The Money (OTM)

What Is Out Of the Money (OTM)?

Out of the money (OTM) is a term used to describe an option contract that only contains intrinsic value. These options will have a delta less than 50.0.

An OTM call option will have a strike price that is higher than the market price of the underlying asset. Alternatively an OTM put option has a strike price that is lower than the market price of the underlying asset.

OTM options may be contrasted with in the money (ITM) options.

Key Takeaways

  • Out of the money means an option has no intrinsic value, only extrinsic value.
  • A call option is OTM if the underlying’s price is below the strike price. A put option is OTM if the underlying’s price is above the strike price.
  • An option can also be in the money or at the money.
  • OTM options are less expensive than ITM or ATM options. This is because ITM options have intrinsic value, and ATM options are very close to having intrinsic value.

Understanding Out Of The Money Options

Option Basics

For a premium, stock options give the purchaser the right, but not the obligation, to buy or sell the underlying stock at an agreed-upon price, known as the strike price, before an agreed-upon date, known as the expiration date.

An option to buy an underlying asset is a call option, while an option to sell an underlying asset is a put option. A trader may purchase a call option if they expect the underlying asset’s price to exceed the strike price before the expiration date. Conversely, a put option enables the trader to profit on a decline in the asset’s price. Because they derive their value from that of an underlying security, options are derivatives.

An option can be OTM, ITM or at the money (ATM). An ATM option is one where the strike price and price of the underlying are equal.

Out of the Money Options

You can tell if an option is OTM by determining where the current price of the underlying is in relation to the strike price of that option. For a call option, if the underlying price is below the strike price, that option is OTM. For a put option, if the underlying’s price is above the strike price, then that option is OTM. An out of the money option has no intrinsic value, but only possesses extrinsic or time value.

Being out of the money doesn’t mean a trader can’t make a profit on that option. Each option has a cost, called the premium. A trader could have bought a far out of the money option, but now that option is moving closer to being in the money (ITM). That option could end up being worth more than the trader paid for the option, even though it is currently out of the money. At expiry, though, an option is worthless if it is OTM. Therefore, if an option is OTM, the trader will need to sell it prior to expiry in order to recoup any extrinsic value that is possibly remaining.

Consider a stock that is trading at $10. For such a stock, call options with strike prices above $10 would be OTM calls, while put options with strike prices below $10 would be OTM puts.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

OTM options are not worth exercising, because the current market is offering a trade level more appealing than the option’s strike price.

Out of the Money Options Example

A trader wants to buy a call option on Vodafone stock. They choose a call option with a $20 strike price. The option expires in five months and costs $0.50. This gives them the right to buy 100 shares of the stock before the option expires. The total cost of the option is $50 (100 shares * $0.50), plus a trade commission. The stock is currently trading at $18.50.

Upon buying the option, there is no reason to exercise it because by exercising the option they have to pay $20 for the stock, when they can currently buy it at a market price of $18.50.

This option is OTM, but that doesn’t mean it is worthless yet. The trader just paid $0.50 for the potential that the stock will appreciate above $20 within the next five months.

If the option is OTM at expiry it is worthless, but prior to expiry, that option will still have some extrinsic value which is reflected in the premium or cost of the option. The price of the underlying may never reach $20, but the premium of the option may increase to $0.75 or $1 if it gets close. Therefore, the trader could still reap a profit on the out of the month option itself by selling it at a higher premium than they paid for it.

If the stock price moves to $22—the option is now ITM—it is worth exercising the option. The option gives them the right to buy at $20, and the current market price is $22. The difference between the strike price and the current market price is known as intrinsic value, which is $2.

In this case, our trader ends up with a net profit or benefit. They paid $0.50 for the option and that option is now worth $2. They net $1.50 in profit or advantage.

But what if the stock only rallied to $20.25 when the option expired? In this case, the option is still ITM, but the trader actually lost money. They paid $0.50 for the option, but the option only has $0.25 of value now, resulting in a loss of $0.25 ($0.50 – $0.25).

The Dangerous Lure of Cheap out of the Money Options

Out of the money (OTM) options are more cheaply priced than at the money (ATM) or out of the money (OTM) options, because the OTM options require the underlying asset to move further in order for the value of the option (called the premium) to substantially increase. What looks cheap isn’t always a good deal, because often things are cheap for a reason. That said, when an OTM option is properly selected and bought at the right time it can lead to large returns, hence the allure.

While buying out of the money options can be a profitable strategy, the probability of making money should be evaluated against other strategies, such as simply buying the underlying stock, or buying in the money or closer to the money options.

The Lure of Out of the Money Options

A call option is considered OTM if the strike price for the option is above the current price of the underlying security. For example, if a stock is trading at $22.50 a share, then the 25 strike price call option is currently “out-of-the-money.”

A put option is considered to be OTM if the strike price for the option is below the current price of the underlying security. For example, if a stock is trading at a price of $22.50 a share, then the 20 strike price put option is “out-of-the-money.”

Degrees of being OTM (and ITM) vary from case to case. If the strike price on a call option is 75, and the stock is trading at $50, that option is way out of the money, and the price of that option will be very little. On the other hand, a call option with a 55 strike is much closer to the $50 current price, and therefore that option will cost more than the 75 strike.

The further out of the money an option is, the cheaper it is because it becomes more likely that underlying will not be able to reach the distant strike price. Likewise, OTM options with a closer expiry will cost less than options with an expiry that is further out. An option that expires shortly has less time to reach the strike price and is priced more cheaply than OTM option with longer until expiry. OTM options also have no intrinsic value, which is another big reason they are cheaper than ITM options.

On the positive side, OTM options offer great leverage opportunities. If the underlying stock does move in the anticipated direction, and the OTM option eventually becomes an ITM option, its price will increase much more on a percentage basis than if the trader bought an ITM option, to begin with.

As a result of this combination of lower cost and greater leverage, it is quite common for traders to prefer to purchase OTM options rather than ATM or ITM options. But as with all things, there is no free lunch, and there are important tradeoffs to take into account. To best illustrate this, let’s look at an example.

Buying the Stock

Let’s assume that a trader expects a given stock will rise over the course of the next several weeks. The stock is trading at $47.20 a share. The most straightforward approach to taking advantage of a potential up move is to buy 100 shares of the stock. This would cost $4,720. For each dollar, the stock goes up/down, the trader gains/losses $100.

Buying an In the Money Option

Another alternative is to purchase an ITM call option with a strike price of $45. This option has just 23 days left until expiration and is trading at a price of $2.80 (or $280 for one contract which controls 100 shares). The breakeven price for this trade is $47.80 for the stock ($45 strike price + $2.80 premium paid). At any price above $47.80, this option will gain, point for point, with the stock. If the stock is below $45 a share at the time of option expiration, this option will expire worthless and the full premium amount will be lost.

This clearly illustrates the effect of leverage. Instead of putting up $4,720 to buy the stock, the trader puts up just $280. For this price, if the stock moves up more than $0.60 a share (from the current price of $47.20 to breakeven of $47.80), the options trader will make a point-for-point profit with the stock trader who is risking significantly more money. The caveat is that the gain has to occur within the next 23 days, and if it doesn’t the $280 is lost.

Buying an Out of the Money Option

Another alternative, for a trader who is highly confident that the underlying stock is soon to make a meaningful up move, is to buy the OTM call option with a strike price of $50. Because the strike price for this option is almost three dollars above the price of the stock ($47.20) with only 23 days left until expiration, this option trades at just $0.35 (or $35 for one contract).

A trader could purchase eight of these 50 strike price calls for the same cost as buying one of the 45 strike price ITM calls. By so doing she would have the same dollar risk ($280) as the holder of the 45 strike price call. The downside risk is the same, although there is a greater percentage probability for losing the entire premium. In exchange for this, there is much larger profit potential. Notice the right side of the x-axis on the graph below. The profit numbers are significantly higher than what was seen on the previous graphs.

The catch in buying the tempting “cheap” OTM option is balancing the desire for more leverage with the reality of simple probabilities. The breakeven price for the 50 call option is $50.35 (50 strike price plus 0.35 premium paid). This price is 6.6% higher than the current price of the stock. So to put it another way, if the stock does anything less than rally more than 6.6% in the next 23 days, this trade will lose money.

Comparing Potential Risks and Rewards

The following chart displays the relevant data for each of the three positions, including the expected profit – in dollars and percent.

The key thing to note in the table is the difference in returns if the stock goes to $53 as opposed to if the stock only goes to $50 a share. If the stock rallied to $53 a share by the time of option expiration, the OTM 50 call would gain a whopping $2,120, or +757%, compared to a $520 profit (or +185%) for the ITM 45 call option and +$580, or +12% for the long stock position.

However, in order for this to occur the stock must advances over 12% ($47.20 to $53) in just 23 days. Such a large swing is often unrealistic for a short time period unless a major market or corporate event occurs.

Now consider what happens if the stock closes at $50 a share on the day of option expiration. The trader who bought the 45 call closes out with a profit of $220, or +70%. At the same time, the 50 call expires worthless and the buyer of the 50 call experiences a loss of $280, or 100% of the initial investment. This is despite the fact that she was correct in her forecast that the stock would rise. it just didn’t rise enough.

The Bottom Line

It is acceptable for a speculator to bet on a big expected move. The key, however, is to first understand the unique risks involved in any position. And secondly, to consider alternatives that might offer a better tradeoff between profitability and probability. While the OTM option may offer the biggest bang for the buck, if it works out, the probability of a far out of the money option becoming worth a lot is a low probability.

These graphs are just examples of profit/loss potential for various scenarios. Each trade is different and option prices are constantly changing as the price of the other underlying and other variables change.

In the Money vs. Out of the Money: What’s the Difference?

In the Money vs. Out of the Money: An Overview

In options trading, the difference between “in the money” (ITM) and “out of the money” (OTM) is a matter of the strike price’s position relative to the market value of the underlying stock, called its moneyness.

An ITM option is one with a strike price that has already been surpassed by the current stock price. An OTM option is one that has a strike price that the underlying security has yet to reach, meaning the option has no intrinsic value.

In the Money

ITM options also have their uses. For example, a trader may want to hedge or partially hedge their position. They may also want to buy an option that has some intrinsic value, and not just time value. Because ITM options have intrinsic value and are priced higher than OTM options in the same chain, the price moves (%) are relatively smaller. That is not to say ITM option won’t have large price moves, they can and do, but, compared to OTM options, the percentage moves are smaller.

Certain strategies call for ITM options, while others call for OTM options, and sometimes both. One is not better than another; it just comes down to what works for the best for the strategy in question.

A call option gives the option buyer the right to buy shares at the strike price if it is beneficial to do so. An in the money call option, therefore, is one that has a strike price lower than the current stock price. A call option with a strike price of $132.50, for example, would be considered ITM if the underlying stock is valued at $135 per share because the strike price has already been exceeded. A call option with a strike price above $135 would be considered OTM because the stock has not yet reached this level.

In the case of the stock trading at $135, and the option strike of $132.50, the option would have $2.50 worth of intrinsic value, but the option may cost $5 to buy. It costs $5 because there is $2.50 of intrinsic value and the rest of the option cost, called the premium, is composed of time value. You pay more for time value the further the option is from expiry because the underlying stock price will move before expiry, which provides an opportunity to the option buyer and risk to the option writer which they need to be compensated for.

Put options are purchased by traders who believe the stock price will go down. ITM put options, therefore, are those that have strike prices above the current stock price. A put option with a strike price of $75 is considered in the money if the underlying stock is valued at $72 because the stock price has already moved below the strike. That same put option would be out of the money if the underlying stock is trading at $80.

In the money options carry a higher premium than out of the money options, because of the time value issue discussed above.

Out of the Money

In the money or out of the money options both have their pros and cons. One is not better than the other. Rather, the various strike prices in an options chain accommodate all types of traders and option strategies.

When it comes to buying options that are ITM or OTM, the choice depends on your outlook for the underlying security, financial situation, and what you are trying to achieve.

OTM options are less expensive than ITM options, which in turn makes them more desirable to traders with little capital. Although, trading on a shoe-string budget is not advised. Some of the uses for OTM options include buying the options if you expect a big move in the stock. Since OTM options have a lower up-front cost (no intrinsic value) than ITM options, buying an OTM option is a reasonable choice. If a stock currently trades at $100, you can buy an OTM call option with a strike of $102.50 if they think the stock will reasonably rise well above $102.50.

OTM options often experience larger percent gains/losses than ITM options. Since the OTM options have a lower price, a small change in their price can translate into large percent returns and volatility. For example, it is not uncommon to see the price of an OTM call option bounce from $0.10 to $0.15 during a single trading day, which is equivalent to a 50 percent price change. The flip side is that these options can move against you very quickly as well, though the risk is limited to the amount paid for the option (assuming you are the option buyer and not the option writer).

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    Best Binary Options Broker 2020!
    Good Choice for Beginners!
    Free Trading Education, Free Demo Account!
    Get a Sign-Up Bonus Now!

  • Binomo
    Binomo

    2nd in our ranking!

Like this post? Please share to your friends:
How To Start Binary Options Trading 2020
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: