Out of The Money (OTM)
Definition and uses of options that carry no intrinsic value
What Is Out of The Money (OTM)?
An option is "out of the money" when the current price of the underlying would give it no intrinsic value if exercised right now. For a call, that means the asset price is BELOW the strike. For a put, it means the asset price is ABOVE the strike. For example, if XYZ trades at $100, a $110 call is OTM (it would need to rise another $10 to have intrinsic value). If XYZ trades at $100, a $90 put is OTM (it would need to fall $10 to have intrinsic value). OTM options have no intrinsic value; their price consists entirely of extrinsic value (time value). OTM options are the cheapest options at any expiration because they require the market to move significantly to gain value. If the market does move in their favour, however, they can produce very large percentage returns because the leverage is greater.
Moneyness and Probability in OTM Options
How far out of the money an option sits is typically measured in dollars or in standard deviations. A $105-strike call when price is $100 is "one strike" or typically 0.5-1 standard deviation OTM, depending on volatility. A $110-strike call is "two strikes" or 1-2 standard deviations OTM. The further OTM an option is, the lower the probability it expires ITM. An option 1-2 strikes OTM might have a 30-40% probability of expiring ITM. An option 3 or more strikes OTM might have less than 15%. Those probabilities feed straight into prices: deep OTM options are very cheap. Buyers of OTM options are effectively betting against unfavourable odds, but if they win the returns are enormous. Sellers of OTM options are betting with the odds, earning small amounts with high regularity.
OTM Buying Strategies
Buyers of OTM options are looking for cheap speculative bets on price moves. The advantage is that the entry price is low, often only cents. If the market moves favourably, the percentage return can be enormous: an option bought at $0.10 that rises to $0.50 is a 400% return. The drawback is that most of these trades lose money; if you buy 10 OTM options, 7 or 8 might expire worthless. Buyers of OTM options need the market to move FAST so the option can accumulate gains while time value remains. Waiting until expiration for an OTM option to become profitable is usually a poor idea, because theta decay will be dramatic. Most OTM buyers have a plan to close quickly if the trade does not move within a set period. Buying OTM options is, within the world of options, the equivalent of a speculative bet: appealing, but risky.
OTM Selling Strategies
Sellers of OTM options are betting that the option will expire worthless. Selling an OTM call is a bet that price will not rise as far as the strike suggests. Selling an OTM put is a bet that price will not fall as far as the strike suggests. The advantage of selling OTM is a high probability of success: an option two strikes OTM might expire worthless 60-70% of the time. The drawback is that the premium collected is small, because the perceived risk is low. Selling OTM options is a "death by a thousand cuts" strategy in reverse: you bank many small gains that add up. It is very popular among professional option sellers who understand risk management. The risk is that if the market moves violently against you, you can be assigned or face very large losses. Sellers of deep OTM options are generally betting on mean reversion: that price will move back toward the strike they are selling.
OTM in Spreads and Complex Strategies
OTM options are used constantly in spreads. A bull call spread buys a call (normally ATM or slightly ITM) and sells another further OTM: a debit structure that caps both the cost and the gain. A bear put spread buys a put and sells another further OTM, also for a debit. Their credit versions are the inverse: the bear call spread sells the nearer call and buys one further OTM, and the bull put spread sells the nearer put and buys one further OTM; both of those collect premium. These spreads carry higher probabilities of success than outright positions. OTM options are also used in iron condors, where you sell both an OTM call and an OTM put to collect premium on both sides. The idea is that both expire worthless, letting the trader keep the entire credit collected. OTM options are likewise the basic building block of many volatility strategies, where the trader is betting on the magnitude of the move rather than its direction. Understanding OTM behaviour is critical to building effective spreads and managing overall strategy risk.