Out of the money (OTM) options are some of the most traded contracts in the options market. They cost less than in-the-money options, which makes them attractive to beginners. However, they also carry higher risk because they can expire completely worthless. Understanding OTM options is essential before you start trading them.
What Does Out of The Money Mean?
An option is "out of the money" when it has no intrinsic value. If you exercised the option right now, you would lose money (which is why no one does that).
Simple rule:
- Call option: OTM when stock price is BELOW the strike price
- Put option: OTM when stock price is ABOVE the strike price
OTM Call Options
A call is out of the money when the stock would need to rise before the call has any exercise value.
Example: OTM Calls
Stock ABC is trading at $50.
- $55 strike call: OTM by $5 (stock needs to rise $5 to reach strike)
- $60 strike call: OTM by $10 (stock needs to rise $10)
- $70 strike call: OTM by $20 (stock needs to rise $20)
None of these calls have intrinsic value. Their entire price is extrinsic (time) value.
OTM Put Options
A put is out of the money when the stock would need to fall before the put has any exercise value.
Example: OTM Puts
Stock XYZ is trading at $100.
- $95 strike put: OTM by $5 (stock needs to drop $5 to reach strike)
- $90 strike put: OTM by $10 (stock needs to drop $10)
- $80 strike put: OTM by $20 (stock needs to drop $20)
These puts have no intrinsic value and will expire worthless if the stock stays above their strikes.
Key Characteristics of OTM Options
No Intrinsic Value
The entire price of an OTM option is extrinsic value. You are paying purely for time and the potential that the stock might move in your favor.
Lower Cost
OTM options are cheaper than ITM or ATM options. This makes them accessible to traders with smaller accounts.
Lower Delta
OTM options have lower delta, typically between 0.05 and 0.40. They move less for each dollar the stock moves. A far OTM call might only gain $0.10 when the stock rises $1.
Higher Percentage Gains (or Losses)
Because OTM options are cheap, a small absolute move represents a large percentage change. A $0.50 option that moves to $1.00 is a 100% gain.
Higher Risk of Total Loss
OTM options frequently expire worthless. The stock must move past the strike price before expiration, or you lose your entire investment.
Key statistic: Many OTM options expire worthless. The further out of the money, the lower the probability of profit. A far OTM option might only have a 10-20% chance of finishing in the money.
When to Use OTM Options
Speculating on Big Moves
If you expect a significant move (earnings, FDA approval, etc.), OTM options offer the highest percentage returns. However, the stock needs to move substantially for you to profit.
Hedging/Insurance
OTM puts are commonly used as portfolio insurance. They are cheap and protect against large drops. Think of them like paying a small premium for disaster insurance.
Selling Premium
Many traders sell OTM options to collect premium, betting that the stock will not reach the strike. This is the basis of strategies like iron condors and credit spreads.
Limited Capital
Traders with smaller accounts sometimes use OTM options because they are more affordable. However, this can be a trap if you consistently lose your premium.
Example: OTM vs ITM Trade Outcome
Stock is at $100. You are bullish with $500 to spend:
- $95 call (ITM): Costs $8.00 - you can buy 0.6 contracts ($480)
- $105 call (OTM): Costs $2.00 - you can buy 2.5 contracts ($500)
If stock goes to $110 at expiration:
- ITM call: Worth $15, you make ($15 - $8) x 60 = $420 (87% return)
- OTM call: Worth $5, you make ($5 - $2) x 250 = $750 (150% return)
If stock stays at $100 at expiration:
- ITM call: Worth $5, you lose ($8 - $5) x 60 = -$180 (37% loss)
- OTM call: Worth $0, you lose $500 (100% loss)
The Danger of Cheap OTM Options
Many beginners are attracted to OTM options because they are cheap. "Why pay $5 when I can pay $0.50?" This thinking can be dangerous:
- They are cheap for a reason: Low probability of profit
- Time decay accelerates: OTM options lose value faster as expiration approaches
- You need big moves: Small favorable moves are not enough
- Break-even is far away: The stock needs to move significantly past the strike
Warning: Consistently buying cheap, far OTM options is one of the fastest ways to lose money in options trading. The occasional big winner rarely compensates for all the losses.
Calculating Your Breakeven for OTM Options
OTM Call Breakeven: Strike Price + Premium Paid
OTM Put Breakeven: Strike Price - Premium Paid
Example: Breakeven Calculation
Stock at $50. You buy a $55 call for $1.00:
- Breakeven = $55 + $1 = $56
- The stock needs to rise 12% just to break even
- At $55, you still lose money (the option is worth $0 at expiration)
OTM Options at Expiration
OTM options expire worthless. There is no exercise, no assignment, and no shares changing hands. The option simply disappears and you lose the premium paid.
If you sold OTM options, they expire worthless and you keep the full premium collected. This is why many professional traders prefer selling OTM options rather than buying them.
Track Your OTM Trades
Pro Trader Dashboard shows you your win rate on OTM vs ITM trades. Discover whether buying cheap options is actually working for you or just draining your account.
Summary
Out of the money options have no intrinsic value - they are all premium based on time and potential. Calls are OTM when the stock is below the strike; puts are OTM when the stock is above the strike. OTM options are cheaper but riskier, often expiring worthless. They can offer high percentage returns on big moves but require the stock to move significantly past the strike to profit. Use them selectively, not as your default strategy.
Learn more about in the money options or understand at the money options.