The Basics: Strike Price and Market Price
Let’s review some foundational concepts:
- Strike Price: The price at which you have the right to buy (for calls) or sell (for puts) the underlying asset
- Market Price: The current trading price of the underlying asset
- Intrinsic Value: The amount by which an option is in-the-money – i.e. the immediate value the option would have if exercised at that moment, before considering costs such as premium paid.
- OTM options have no intrinsic value
- Exercise: To exercise an option means to make use of the contractual right - i.e., that is to buy (for calls) or sell (for puts) the asset at the strike price. However, exercising may not always be the most beneficial course of action and depends on factors such as market conditions, time value, and transaction costs.
What Are Out-the-Money (OTM) Options?
An option is "out-the-money" when exercising it would not result in any intrinsic value based on the current relationship between the strike price and the market price (excluding the premium paid and any associated costs). Let’s look at some examples.
Important: These examples are for illustrative purposes only. They do not constitute investment advice or a recommendation to trade. Options are complex products and are not suitable for all investors. Capital is at risk.
For Call Options:
Condition: Market Price < Strike Price
A call option is considered out-the-money (OTM) when the market price of the underlying asset is below the strike price.
Example: You hold a Netflix (NFLX) call option with a strike price of £500. If Netflix is currently trading at £450, your option is out-the-money by £50. Exercising this option would result in paying more than the current market price for the shares.
Explanation: When the market price is below the strike price, there's no intrinsic value, and exercising the option would not be economically beneficial based on current prices.. However, the option may still retain (time) value if there's time remaining before expiration, as the price of the underlying asset could move.
For Put Options:
Condition: Market Price > Strike Price
A put option is considered out-the-money (OTM) when the market price of the underlying asset is above the strike price.
Example: You hold an Apple (AAPL) put option with a strike price of £150. If Apple is currently trading at £170, your option is out-the-money by £20. Exercising this option would mean selling shares at £150 when for the current market price is £170.
Explanation: When the market price is above the strike price, the option has no intrinsic value, and exercising it would result in selling below the market value. However, the option may still retain extrinsic (time) value if there is time remaining until expiration, as the market price could change.
Out-the-money Options Have Only Extrinsic Value
OTM options do not have intrinsic value and are priced based entirely on time value and market expectations.
OTM options have no intrinsic value. Their market price reflects only "extrinsic value" (which includes time value and implied volatility). These options may still hold value because traders may be willing to pay for the potential that they become in-the-money (ITM) before expiration.
Example: You hold a Microsoft (MSFT) call option with a strike price of £300 and the stock is trading at £320, your option has an intrinsic value of £20 per share. If the option is currently trading at £25, then £20 is intrinsic value, and the remaining £5 is extrinsic value.
Price Dynamics and Trading Considerations
Premium Costs
OTM options generally have a lower premium than ITM options (with the same underlying asset and expiration) but have a lower probability of profitable exercise
Example: An NVIDIA (NVDA) call option with a strike price of £700 when NVIDIA is trading at £750 (ITM) might cost £60 (£50 intrinsic value + £10 extrinsic value), while a call option with a strike price of £800 (OTM) might only cost £15 (£0 intrinsic value + £15 extrinsic value).
Explanation: The ITM option’s price reflectls both £50 of intrinsic value plus extrinsic value, whereas the OTM option's price consists entirely of extrinsic value reflecting the possibility of the stock rising above £800 before expiration.
Risk and Reward Profiles
OTM options offer leverage with lower capital requirements and the potential for higher percentage returns, however they carry a significantly higher risk of expiring worthless (resulting in a total loss of the premium paid).
Example: If you invest £1,000 in ITM SPY call options and the market moves favorably by 5%, your options might gain 20-30% in value. In contrast, investing £1,000 in OTM SPY call options with the same market movement might yield a 50-100% - but also carries the risk of a complete loss if the market doesn't move sufficiently to bring the options ITM by expiration.
Strategic Applications
When to Consider OTM Options
- When to consider OTM Options
- Investors with a high risk tolerance and a strong market view may consider using OTM options to gain leveraged exposure to price movements..
- Lower premiums allow exposure to underlying assets that might otherwise be inaccessible due to capital constraints.
- For portfolio hedging strategies:
- OTM put options may be used as a form of risk management by providing potential downside protection during market declines.Because the premiums are lower than for ITM options, this may reduce the overall cost of hedging — although protection is only realised if the options become ITM..
- For Limited Loss positions
- The defined premium paid for an OTM option represents the maximum potential loss, which can help manage risk in certain market scenarios. means your maximum loss is lower
At-the-Money (ATM) Options: The Middle Ground
Important: This example is for illustrative purposes only. Options are complex products and not suitable for all investors. Capital is at risk.
For clarity and completeness, it's also important to consider "at-the-money" (ATM) options, where the strike price is approximately equal to the current market price of the underlying asset. Let’s look at an example.
Example: If Microsoft is trading at exactly £300 and you hold a Microsoft call or put with a £300 strike price, your option would be considered at-the-money.
Explanation: ATM options are viewed as the transition point between ITM and OTM. They have no intrinsic value ,as the strike price is equal to (or very close) to the current market price.
Recap
Out-the-money (OTM) options generally have a lower cost than in-the-money options because they have no intrinsic value (their price reflects only extrinsic factors such as time value and implied volatility). While their lower cost may make them suitable for defined-risk strategies or for investors anticipating significant price movements, they also carry a higher probability of expiring worthless if the market does not move in the expected direction.
For OTM call options, the market price is below the strike price; for OTM puts, the strike price is below the market price. As a result, exercising an OTM option would not provide a financial benefit at that moment. However, OTM options may still form part of strategies that seek to benefit from potential market movements before expiration.