Definition
“Out of The Money” (OTM) is a term used in options trading to describe an option that has no intrinsic value. In a call option, an option is considered OTM if the strike price is greater than the market price of the underlying asset. In a put option, an option is OTM if the strike price is less than the market price of the underlying asset.
Phonetic
The phonetics of “Out of The Money (OTM)” are as follows:Out – /aʊt/of – /ʌv/the – /ðə/Money – /ˈmʌni/OTM – /ˌəʊtiːˈɛm/So, it would phonetically be pronounced as: aʊt ʌv ðə ˈmʌni or ˌəʊtiːˈɛm.
Key Takeaways
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- Out of The Money (OTM) refers to a situation in which an investor has bought an option with a strike price that is either above (call option) or below (put option) the current market price of the underlying asset. This means the option has yet to reach its strike price and is not beneficial to exercise at the moment.
- OTM options may be less expensive than in-the-money or at-the-money options. Thus, they are often used as a less capital-intensive way to take a position on the future price movements of an underlying asset.
- However, because an OTM option requires the underlying asset’s price to move before the option becomes profitable, there’s a significant risk associated with purchasing OTM options. The risk is that the price might not move as expected, and the option could expire worthlessly, resulting in a total loss of the premium paid to purchase the option.
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Importance
The business/finance term “Out of The Money” (OTM) is crucial as it refers to an option that hasn’t yet reached its strike price, thus currently holds no intrinsic value and only possesses extrinsic or time value. This concept is predominantly used in the context of call and put options in option trading. A call option is OTM if the market price is below the strike price, and a put option is OTM if the market price is above the strike price. Understanding “Out of The Money” is vital for investors since it helps to estimate the risk and potential return involved in an option contract, influencing decisions on whether or not to enter such a contract. It also allows investors to form strategies like OTM options selling for collecting premium with limited risk, provided the option continues to stay OTM.
Explanation
Out of The Money (OTM) is a term used primarily in the context of options trading, conveying significant information about an option’s intrinsic value and profitability potential. The purpose of the term OTM is to assist investors in determining whether to exercise the option or not. Investors classify an option as OTM when, for a call option, the strike price (the price at which an option buyer can purchase the underlying asset) is higher than the current market price of the underlying asset. Conversely, for a put option, it’s OTM if the strike price is lower than the current market price.The OTM concept is crucial as it aids traders in making informed investment decisions based on the potential for profit or losses. It plays a critical role for speculators who purchase OTM options hoping that the underlying asset will move significantly, leading to a substantial payout. On the other hand, sellers of OTM options aim to benefit from the premium charged to the buyer, particularly if they speculate that the market price will not reach the strike price. Investors use OTM to evaluate option premiums, risk levels, and potential return on investment, underscoring its necessity in option trading.
Examples
1. Stock Options: Let’s say you have a call option (the right to buy) for Apple stock at a strike price of $150 per share. If the current market price of Apple is at $125, then your call option is Out of The Money (OTM). Because buying at the current market price is cheaper than exercising your call option, it’s not beneficial to exercise the option. 2. Currency Options: Suppose you have a USD/GBP put option with a strike price of 0.8 (you have the right to sell USD in exchange for GBP at this rate), but the current market exchange rate is 0.9. In this case, you wouldn’t want to exercise your option because you can get more GBP for your USD on the open market. Therefore, your put option is OTM.3. Commodity Futures Contracts: Assume you’re holding a futures contract that gives you the ability to buy a barrel of oil at $75. If the market price drops to $65 per barrel, your contract is OTM as it would be cheaper for you to buy the oil at the prevailing market rate rather than honor the futures contract at the agreed higher rate.
Frequently Asked Questions(FAQ)
What does Out of The Money mean in finance?
Out of The Money (OTM) is a term used in options trading to describe a financial contract wherein the strike price (the price at which a contract can be exercised) is more expensive than the current market price of the underlying asset.2.
When is a call option considered to be OTM?
A call option is referred to as OTM when the strike price is higher than the current market price of the underlying asset. The option would not generate profit if it were executed at that time.3.
When is a put option considered to be OTM?
A put option is OTM when the strike price is lower than the current market price of the underlying asset. Exercising the option at that moment would not yield a profit.4.
What happens to OTM options at expiry?
OTM options have no intrinsic value and thus, will expire worthless. The contract holder wouldn’t exercise the option because it is not profitable to sell or buy the asset at the strike price.5.
Can OTM options still be profitable?
Yes, an OTM option can still be profitable before expiration. If there’s a significant move in the market and the price of the underlying asset reaches a level where it becomes profitable to exercise the option, then the OTM option can make a profit.6.
Why would people buy OTM options?
Investors may buy OTM options because they are usually cheaper than in-the-money options. They are betting on the chance that the market will move in a desired direction, making the option profitable before it expires.7.
How is an OTM option different from In The Money (ITM) and At The Money (ATM) options?
OTM, ITM, and ATM refer to the relationship between an option’s strike price and the current market price of the underlying asset. OTM means the strike price is not favorable for profitable exercise, ITM means it is, and ATM means the strike price and market price are equal.8.
How does volatility impact OTM options?
An increase in volatility makes OTM options more valuable. This happens because higher volatility increases the probability of the option moving from OTM to ITM before expiration.9.
What risks are associated with buying OTM options?
The main risk of buying an OTM option is the possibility of losing the entire investment if the option remains OTM until it expires. Meanwhile, the potential benefits are limited to the amount that the option’s intrinsic value exceeds the premium paid.10.
How are OTM options typically used in investment strategies?
OTM Options are often used in advanced strategies such as spreads, straddles, and strangles. They provide investors with leverage and insurance without the need to buy or sell the underlying asset at its current market price.
Related Finance Terms
- In The Money (ITM)
- Strike Price
- Option Premium
- Call Option
- Put Option
Sources for More Information
