Before we begin explaining the classifications of Options contracts, let us familiarize ourselves with some terms which are essential in the overall understanding of the concept.
Options are, as the term suggests, an opportunity for the purchase to buy a particular stock at an agreed-upon price by an agreed-upon date (also known as the expiration date). This opportunity does not make an obligation and the purchaser can refuse to exercise the option of buying the stock, if not deemed fit. Hence, to enable this facility there is a certain premium associated with such options’ contract.
Call Option means the option to buy the said asset.
Put Option means the option to sell the said asset.
Moneyness is used to describe the intrinsic value of an option’s premium in the stock market. It can potentially guide options holders to understand the likelihood of making a profit by using this option.
The intrinsic value of a stock is best understood as the difference between its current market price and the strike price.
The strike price is the actual transaction price in which the stock/asset is eventually sold.
What are OTM Options?
Out of the Money options or OTM options is a term used to refer to the options under which there is no intrinsic value, instead only extrinsic value. In other words, OTM options require the underlying stock to gain at price significantly in order for the investor to make a profit. What usually makes them appealing is that they are one of the cheapest to buy in terms of overall purchasing expense incurred. Like the other options such as In The Money (ITM), and At The Money (ATM), OTM options to provide the investor with the choice of a call and/or a put.
OTM call options imply that the stock’s market price is currently lower than the strike price. On the other hand, an option is considered as OTM if the current trading value is higher than the strike price. As the name itself suggests, using OTM calls means you will be out of money, since buying the stock at the market price would have provided more benefit, than what you will spend by exercising the OTM call option’s strike price. Investors can make a profit using the put OTM option by selling the asset when there is a sharp rise in value before the expiration date of the contract. Else, there will be no profit since trading the stock at the market value will give a better return than trading it at the strike price.
Why use OTM Options?
The above definition should not mislead you into believing that there is no profit to be made in OTM options. If that were the case, then there would have been no reason for such a classification to exist as if it would be of no tangible benefit to the trader. The combination of moneyness and premium are important aspects that add cost and value to a stock. An initially bought OTM option may start moving closer towards becoming an ITM (In the Money) option. ITM is associated with a positive intrinsic value and have far higher chances of providing a profit. Hence, if the option is currently Out of The Money, it may not necessarily be the case by the time of the contract’s expiration date. However, if the option is OTM even at the expiration date, then it is pointless executing it. This is because if you exercise the OTM call option at expiration, then you will end up buying the underlying stock at a higher price than what you would have paid had you bought the same stock at the market trading price.
In Summation
Considering the amount of knowledge required to be able to predict whether a stock or an asset can significantly rise by the options contract expiration date, OTM calls are best left to experts and experienced traders. This aggressive way of trading can provide high gains but also has high risk associated with them, hence requires years of experience. Why veteran traders still choose to use OTM options is because the percentage gains that can be derived are highest in this option on the same move of the underlying stock than At The Money Options or In The Money Options. OTM options have the main cost of the premium associated with them, because if you choose not to exercise your option then the whole contract is deemed pretty much worthless. Moreover, if you do plan to exercise the OTM call option or the put option, do not forget the other easily missed aspects like a trading commission or brokerage fees while calculating the actual potential profits. Your total expense should include these as well and then the delta achieved is the actual profit. Else the trade is not worth completing.
Just as there is a high percentage gain if the stock prices rise beyond the strike price while selling, there is also a high percentage of loss in the case of the contrary happening. Using an Out of The Money option requires careful decision-making and constant monitoring of the rise and fall trends of the stock. Plus, you need to account for external global factors which may have an impact on the prices of the underlying stocks.
What is an OTM Call Option? OTM call options imply that the stock's market price is currently lower than the strike price. On the other hand, an option is considered as OTM if the current trading value is higher than the strike price.
In-the-money (ITM) call options are those where the market price is higher than the strike price. If the strike price and spot price are close, then the option is said to be at-the-money (ATM). The out-of-the-money (OTM) call option is one where the market price is lower than the strike price.
Out of the money is also known as OTM, meaning an option has no intrinsic value, only extrinsic value. A call option is OTM if the underlying price is trading below the strike price of the call.
Out of the Money (OTM) options offer lower upfront costs, high leverage potential, and a favorable risk-reward ratio. However, they come with higher risks, a higher probability of expiring worthless, and a lower likelihood of profitability.
Because OTM options have such low premiums they can also provide the trader with a significant amount of leverage because you can control large positions for a small premium. However, it is also true that an OTM option is less sensitive to price moves than the ITM or ATM option.
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Key Takeaways. Out-of-the-money (OTM) options are cheaper than other options since they need the stock to move significantly to become profitable. The further out of the money an option is, the cheaper it is because it becomes less likely that underlying will reach the distant strike price.
However, if the option is OTM even beyond the expiry date, executing it is meaningless. This is because if you execute the OTM call option at expiry, you will wind up paying more for the underlying stock than if you had purchased the identical shares at the market trading price.
One is not better than the other. Rather, the various strike prices in an options chain accommodate all types of traders and option strategies. When it comes to buying options that are ITM or OTM, the choice depends on your outlook for the underlying security, financial situation, and what you are trying to achieve.
OTM options make sense when expecting a bigger move in the underlying asset price. The cheaper premium cost allows exposure with less upfront capital. They are riskier than ITM or ATM options given the lower probability of ending up profitable.
Thus, an Out-the-money put option's entire premium consists of Time value / Extrinsic value and it doesn't have any Intrinsic value. So, NIFTY FEB 8200 PUT would be an example of Out-the-money put option.
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Buying OTM calls are generally preferred over buying OTM puts due to low IV differential. OTM options should be bought only when the underlying forecast is for a fast and large move.
Compared to At-The-Money (ATM) or Out-of-The-Money (OTM) options, ITM call options have lower risk. They have a higher chance of expiring profitably since the stock price is already in a profitable range.
A call option gives you the right but not the obligation to buy the underlying security, while a put option gives you the right, but not the obligation, to sell the underlying security. 1You can buy and sell options that are “in the money” or “out of the money.” Each strategy has pros and cons.
Selling OTM options is always a great foundation for any portfolio of derivatives. Given the fact there is always a buffer between the strike price of the option contract and where the stock price is, short OTM options always produce high probability trades that put time on the side of the trader.
Since OTM options have a lower up-front cost (no intrinsic value) than ITM options, buying an OTM option is a reasonable choice. If a stock currently trades at $100, you can buy an OTM call option with a strike of $102.50 if they think the stock will reasonably rise well above $102.50.
ITM options have higher premium costs but also higher probabilities of finishing in the money by expiration. OTM options are cheaper but have lower probabilities of profit. Traders must weigh the tradeoffs. OTM options offer greater leverage due to the lower premium cost.
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