What Is an Out-of-the-Money Option? Beginner Guide

Introduction

What is an out-of-the-money option? An out-of-the-money option, often abbreviated as OTM, is an option contract that currently has no intrinsic value because exercising the contract would not produce an immediate financial benefit.

Understanding how out-of-the-money options work is important because many options traders use these contracts to speculate on future price movements. Although out-of-the-money options do not currently contain intrinsic value, they may gain value if the price of the underlying stock moves in a favorable direction before expiration.

Because these options are not yet profitable to exercise, their value consists entirely of extrinsic value, which reflects time and market expectations.

What Is an Out-of-the-Money Option in Options Trading?

To understand what an out-of-the-money option is in options trading, it is helpful to compare the stock price with the strike price of the option.

For a call option, the contract is considered out-of-the-money when the stock price is below the strike price.
For a put option, the contract is considered out-of-the-money when the stock price is above the strike price.

In both cases, exercising the option would not be profitable because the market price is more favorable than the contract price.

Because these options have no intrinsic value, their price is based entirely on the possibility that the stock price may move favorably before the expiration date.

How Out-of-the-Money Options Work

Understanding how out-of-the-money options work helps traders evaluate the potential risks and rewards associated with these contracts.

Since out-of-the-money options contain no intrinsic value, their price is determined entirely by extrinsic value. This means factors such as time remaining before expiration and implied volatility play an important role in determining their premium.

If the underlying stock moves in the right direction, the option may eventually become at-the-money or in-the-money, which can increase the value of the contract. However, if the stock price does not move as expected before expiration, the option may expire worthless.

Example of an Out-of-the-Money Option

A simple example can help explain how an out-of-the-money option works.

Imagine a stock currently trading at $40 per share.

A trader buys a call option with a $50 strike price.

Because the stock price is still below the strike price, the call option is considered out-of-the-money. Exercising the option would not make sense because the trader could purchase the stock at the lower market price instead.

However, if the stock price rises above $50 before the option expires, the option may gain intrinsic value and become in-the-money.

Put options work in the opposite way. If the stock price is above the strike price, the put option is considered out-of-the-money.

Why Traders Use Out-of-the-Money Options

Out-of-the-money options are popular among traders because they typically have lower premiums compared to in-the-money options.

This lower cost allows traders to control option contracts with less capital. Some traders use out-of-the-money options when they expect large price movements in the underlying stock.

However, these options carry a higher risk of expiring worthless because the stock must move significantly before the contract becomes profitable. For this reason, traders often evaluate the probability of price movement before purchasing out-of-the-money options.

Conclusion

Understanding what an out-of-the-money option is helps traders evaluate how option contracts behave when they do not yet contain intrinsic value. An option is considered out-of-the-money when exercising the contract would not produce an immediate profit.

Although these options currently have no intrinsic value, they may gain value if the underlying stock moves in a favorable direction before expiration. Learning how out-of-the-money options work helps investors better understand the different types of option contracts and how they respond to changes in stock prices.

Lesson 12 of 15 – Options Trading Basics