Options trading can seem complex, but grasping key concepts like out-of-the-money (OTM) options helps demystify the process. In this guide, I break down what OTM options are, why traders use them, and how to evaluate their risks and rewards.
Table of Contents
What Are Out-of-the-Money Options?
An option is out-of-the-money when exercising it would not yield a profit. For a call option, this happens when the underlying asset’s price is below the strike price. For a put option, it occurs when the asset’s price is above the strike price.
Key Definitions
- Call Option: Gives the holder the right to buy an asset at a predetermined price (strike price).
- Put Option: Grants the holder the right to sell an asset at a predetermined price.
Mathematical Representation
For a call option:
S < KFor a put option:
S > KWhere:
- S = Current stock price
- K = Strike price
Why Trade Out-of-the-Money Options?
OTM options are cheaper than in-the-money (ITM) or at-the-money (ATM) options. This affordability makes them attractive for speculative strategies.
Advantages
- Lower Premium Costs – OTM options require less upfront capital.
- Higher Leverage – Small price movements can yield significant percentage gains.
- Defined Risk – The maximum loss is the premium paid.
Disadvantages
- Lower Probability of Profit – The asset must move significantly to become profitable.
- Time Decay (Theta) – OTM options lose value rapidly as expiration nears.
Comparing OTM, ATM, and ITM Options
| Option Type | Call Condition | Put Condition | Premium Cost | Probability of Profit |
|---|---|---|---|---|
| OTM | S < K | S > K | Lowest | Lowest |
| ATM | S = K | S = K | Moderate | Moderate |
| ITM | S > K | S < K | Highest | Highest |
Pricing Out-of-the-Money Options
The Black-Scholes model helps estimate an option’s price. The formula for a call option is:
C = S \cdot N(d_1) - K \cdot e^{-rT} \cdot N(d_2)Where:
- C = Call option price
- N(d) = Cumulative standard normal distribution
- r = Risk-free interest rate
- T = Time to expiration
For OTM calls, N(d_1) and N(d_2) are small, leading to a lower premium.
Example Calculation
Assume:
- Stock price (S) = $100
- Strike price (K) = $110 (OTM call)
- Time (T) = 1 year
- Volatility (\sigma) = 20%
- Risk-free rate (r) = 2%
Using Black-Scholes, the call price might be $3.50, much cheaper than an ATM call at $7.00.
Strategies Involving OTM Options
1. Long OTM Calls (Speculative Bet)
- When Used: Expecting a sharp price rise.
- Risk: Losing the entire premium if the stock doesn’t rise above K.
2. Selling OTM Puts (Income Generation)
- When Used: Bullish on a stock but willing to buy at a lower price.
- Risk: Obligation to buy the stock if it falls below K.
3. OTM Spreads (Defined Risk)
- Combining OTM calls/puts to limit risk.
- Example: Bull Call Spread – Buy OTM call, sell higher OTM call.
The Role of Implied Volatility
OTM options are sensitive to implied volatility (IV). High IV increases premiums, making OTM options more expensive. Traders use the Greeks to measure sensitivity:
- Delta: Rate of price change relative to the stock. OTM calls have low delta (e.g., 0.20).
- Theta: Time decay. OTM options lose value quickly.
- Vega: Sensitivity to volatility. OTM options have high vega.
Real-World Example: Tesla OTM Call
In 2020, Tesla (S = \$400) had OTM calls at K = \$500. When the stock surged to \$800, these calls skyrocketed in value, turning small investments into massive gains.
Risks to Consider
- Expiration Worthlessness – Most OTM options expire worthless.
- Liquidity Issues – Some OTM options have wide bid-ask spreads.
- Overleveraging – Cheap premiums tempt traders to take oversized positions.
Final Thoughts
OTM options offer high-reward potential but require careful risk management. I recommend beginners start with small positions and understand the Greeks before diving deep.
