This page explains the term out of the money (OTM), how to tell which options are out of the money, and their typical characteristics.
Out of the money, often referred to under the acronym OTM, is one of three states of the so called option moneyness. The other two are in the money (ITM) and at the money (ATM).
Moneyness relates to an option’s intrinsic value and depends on the relationship between underlying price and the option’s strike price. This relationship affects moneyness differently for calls and puts.
Which Options are Out of the Money
A put option is out of the money when underlying price is below its strike price.
In other words, at a particular moment, given a particular underlying price, call options whose strikes are greater than underlying price are out of the money.
Out of the money options have no intrinsic value. Exercising an OTM call option doesn’t make sense, because it represents the right to buy the underlying stock at its strike price, which is more expensively than you could buy the stock in the stock market (for underlying price).
For put options it is exactly the opposite, because puts represent rights to sell the underlying at strike price, and therefore higher strikes make put options more valuable. High strike puts (with strike price greater than underlying price) are in the money, while low strike puts (with strikes below underlying price) are out of the money. Exercising OTM put options doesn’t make sense, because you would be selling the underlying stock for less (the strike price) than you could sell it in the stock market (underlying price).
All OTM Options Are Not Equal
The difference between strike price and underlying price matters. Options where these two prices are relatively close are more valuable, because it would take only a small underlying price move for the option to get into the money. On the contrary, when the difference is very big, the probability of the option getting into the money is quite small, which also translates to lower option premium and different characteristics.
Moneyness should not be considered only in terms of the ITM/ATM/OTM bins, but more like a scale. Some ITM options are more (deeper) in the money than others. Similarly, some OTM options are further away from the money than other OTM options.
Far Out of the Money Options
“Far OTM option” is an expression commonly used to describe an OTM option with big difference between strike price and underlying price. The characteristics of OTM options, which we will discuss below, generally apply the more the further away from the money a particular option is.
Common Characteristics of OTM Options
Out of the money options are often very attractive for hedgers and speculators alike, mainly for their relatively low prices and leverage.
OTM options are generally cheaper than ITM options, because you don’t pay for intrinsic value. Prices of OTM options consist of time value only. The rate of time decay can be very fast and costly for OTM options, particularly percentage-wise, even earlier in the option’s life and long before expiration.
Thanks to lower prices, OTM options can provide significant leverage – you can control a big position for relatively cheap premium. That said, OTM options are less sensitive to underlying price moves than ATM and ITM options. As an option gets further out of the money, its delta approaches zero.
Conversely, because their entire value is made of time value, OTM options can be very sensitive to volatility. Vega is greatest at the money in absolute terms, but relative to option premium it is very significant for OTM options. Due to relatively high vega and low delta, OTM options are often used for (long or short) volatility based trades.