Table of contents
- What is a strike price?
- What does out-of-the-money (OTM) mean?
- Do OTM options have any value?
- Out-of-the-money option examples
- Benefits of utilising out-of-the-money (OTM) options
- What happens when an option expires out of the money?
- Essential considerations before using OTM call options
An investor might come across several aspects of trading when involved in trading. It includes various trading strategies or techniques that enable them to incur profits. So, you must know how to execute them to maximise your investment. For example, a financial contract involving a call option gives the investor of the option the right to invest in an asset in a specific time period at a fixed price. This asset could be a commodity, stock, or bond, which is referred to as an underlying asset.
OTM call option or Out-the-Money call options have an essential role to play in options trading. However, you must learn about a strike price before gaining knowledge about what is OTM call option.
What is a strike price?
Strike price refers to the predetermined price to buy or sell OTM call option. The strike price in a call option implies the price at which an option holder buy ITM call and sell OTM call options.
What does out-of-the-money (OTM) mean?
You might wonder what is OTM call option. “Out-of-the-money” (OTM) is a term utilised to characterise an option lacking intrinsic value, with its entire value being deemed extrinsic. Generally, “moneyness” refers to the correlation between the present price of the underlying asset and the option’s strike price, classified into in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM).
A call option is categorised as OTM call option when the current market price of the underlying asset is less than the option’s strike price. In such a scenario, exercising the option would not be profitable, as it would involve purchasing the asset at a price higher than its current market value.
Conversely, a put option is deemed OTM when the underlying asset’s current market price exceeds the strike price. Exercising the put option would not be advantageous, as it would involve selling the asset at a price lower than its current market value.
For an OTM call option, the premium (or value) is entirely comprised of time value and external factors, as these options possess no intrinsic value.
Do OTM options have any value?
Out-of-the-money options may appear without merit, given the apparent lack of incentive to exercise them. Why would anyone opt to execute the right to sell OTM call option below their actual worth or acquire shares at a price higher than their market value, primarily when they could engage in regular share transactions at prevailing market rates?
However, it’s crucial to recognise that OTM call option still possess intrinsic value, albeit lacking. The worth of an options contract is predominantly determined by three factors: its intrinsic value, time value (the duration until expiration), and the volatility of the underlying stock or asset.
Consequently, out-of-the-money options do hold value. The value of such options increases with a lengthier time until the contract’s expiration and heightened volatility of the underlying asset.
Out-of-the-money option examples
Example 1: Call Option
Imagine a scenario where a stock is valued at ₹ 30, and an investor possesses a call option with a strike price of ₹ 40. Given that the market price (₹ 30) is lower than the strike price (₹ 40), this call option is classified as out-of-the-money (OTM).
Example 2: Put Option
In a different situation, suppose a stock is valued at ₹ 70, and an investor holds a put option with a strike price of ₹ 60. In this case, the market price surpassing the strike price designates this put option as out-of-the-money (OTM).
Benefits of utilising out-of-the-money (OTM) options
OTM call option presents unique advantages, which have significantly contributed to their broad appeal. Let’s examine the compelling reasons motivating traders to consider exploring OTM options:
- Potential for Larger Percentage Gains
Differing from their in-the-money and at-the-money counterparts, out-of-the-money (OTM) options can generate higher percentage gains for comparable price movements in the underlying asset.
- Cost Efficiency
Since they lack intrinsic value, out-of-the-money options generally have a lower absolute cost than in-the-money or at-the-money options.
- Reduced Price Point
Out-of-the-money (OTM) options are priced more affordably than options with a strike price closer to the current market price.
- Calculated Risk
Out-of-the-money (OTM) options afford traders a risk profile that can be calculated with greater precision than alternative strategies.
What happens when an option expires out of the money?
Your position in the contract dictates whether the trade concludes in a loss. For the buyer (whether it’s a call or put): If the option, such as a call or put, expires out-of-the-money, you would incur a loss equivalent to the premium you paid. Conversely, as the seller, whether dealing with a call or put option, if it expires out-of-the-money, you emerge victorious without incurring any losses.
Essential considerations before using OTM call options
Leveraging OTM call option can be a beneficial strategy for investors. Nevertheless, it is imperative to approach them with caution and a comprehensive understanding of both their advantages and risks. Here are some essential considerations to bear in mind when employing OTM call options:
- Understand the Basics: Before immersing yourself in out-of-the-money (OTM) call options, ensure you thoroughly comprehend how options operate. Familiarise yourself with key concepts such as strike prices, expiration dates, premiums, and the distinction between call and put options.
- Risk Tolerance: Carefully evaluate your risk tolerance. While out-of-the-money (OTM) call options may come at a lower cost compared to in-the-money (ITM) or at-the-money (ATM) options, they also carry higher risks. The entire premium can be lost if the option expires without value.
- Market Research: Conduct comprehensive research on the underlying asset. Gain insights into the company, its financials, and the factors that might impact its price. A robust fundamental or technical analysis can prove advantageous since out-of-the-money (OTM) call options involve speculation.
- Volatility: Take into account the volatility of the underlying asset. Stocks with high volatility might be more appropriate for out-of-the-money (OTM) call options, as they present a greater likelihood of experiencing substantial price fluctuations.
- Time Horizon: Define your investment time horizon. Out-of-the-money (OTM) call options come with expiration dates, and the greater the time until expiration, the more opportunity exists for the market to move in your favor. Be mindful of the impact of time decay.
- Price Target: Establish a precise price target. OTM call option turns profitable when the underlying asset’s price makes a substantial upward movement beyond the strike price. Set pragmatic and attainable price targets grounded in your analysis.
- Position Sizing: Thoughtfully evaluate the size of your position. Avoid allocating more capital than you can afford to lose. Implement diversification in your investments to manage risk effectively.
- Exit Strategy: Pre-plan your exit strategy. Determine the specific conditions under which you will sell OTM call option if the market moves favourably and establish a threshold for cutting losses if it doesn’t. Adhere to your predetermined plan to prevent emotional decision-making.
Out-of-the-Money (OTM) options offer reduced initial costs, substantial leverage potential, and a favorable risk-reward ratio. Nonetheless, they entail heightened risks, an increased likelihood of expiring without value, and a diminished probability of profitability. Traders and investors must meticulously assess these pros and risk of writing OTM call option, aligning their options trading strategies with their risk tolerance and investment goals within the dynamic landscape of financial markets.
Upon expiration, out-of-the-money options become devoid of value.
Out-of-the-money options retain time (extrinsic) value because there exists a probability that the option may become profitable by the time of expiration. Consequently, the longer the time until expiration, the greater the value of an out-of-the-money option, all else equal. This is due to the increased opportunities for the underlying asset to move favourably within an extended timeframe.
An option with a zero delta would be the furthest out-of-the-money (OTM), as it essentially has no likelihood of ending in a profitable position. Such an option will likely have minimal value and a delta very close to zero.
Indeed, out-of-the-money (OTM) options lack any intrinsic value.