Out-of-the-Money (OTM) is a term used in options trading to describe an option that currently holds no intrinsic value. This occurs when the strike price is unfavorable relative to the current market price of the underlying asset. OTM options consist solely of time value. If the market price does not move favorably before the option's expiration date, OTM options expire worthless.
A call option is considered OTM when its strike price is higher than the current market price of the underlying asset. For example, if X Coin is trading at $40,000, a call option with a $45,000 strike price is OTM. Purchasing at $45,000 is more expensive than buying directly from the market at $40,000.
Conversely, a put option is OTM when its strike price is lower than the current market price of the underlying asset. For instance, if Y Coin is trading at $3,000, a put option with a $2,500 strike price is OTM. Selling at $2,500 would result in a loss compared to selling at the market price of $3,000.
OTM options are generally cheaper than their In-the-Money (ITM) or At-the-Money (ATM) counterparts. They lack intrinsic value. OTM options offer higher leverage potential but come with increased risk. Their profitability relies entirely on favorable market movements.
Additionally, OTM options are highly sensitive to time decay. They lose value rapidly as expiration approaches. Traders often use OTM options for speculative bets or hedges, anticipating significant price movements in the underlying asset.
Consider a stock trading at $50:
These options reflect only the time value. Exercising them at current market prices is not advantageous.
The premium of an OTM option is entirely made up of time value, as there is no intrinsic value. The further an option is from being ITM, the lower its premium.
This reflects the decreased probability of becoming profitable before expiration. Conversely, as an option nears being ITM, its premium increases due to the higher likelihood of yielding a profit.
OTM options are suitable for traders looking to leverage small investments to control larger positions. They are ideal for speculative trades expecting high volatility events, such as earnings reports or major market announcements.
Additionally, some investors use OTM options to hedge existing positions against unexpected price swings. This provides a way to manage risk.
In-the-Money (ITM) options have intrinsic value and are priced higher than OTM options due to their favorable strike price relative to the underlying asset's market price.
While ITM options offer immediate profit potential and lower risk of expiring worthless, OTM options are less expensive and provide higher leverage but come with increased risk. The choice between ITM and OTM options depends on the trader’s market outlook, financial situation, and strategic goals.