Out of the money (OTM) Options

Out-of-the-money (OTM) refers to options contracts with no intrinsic value. Out-of-the-money options only have extrinsic value. The further away an options contract is out-of-the-money, the less likely it is to be profitable. Out-of-the-money contracts are require less premium than an option that is at-the-money(ATM) or in-the-money(ITM). 

In the case of a call option, an OTM strike price will be above the price of the underlying asset. Conversely, an OTM put will have a strike price lower than the price of its underlying asset. 

Key Takeaways

• Out-of-the-money options, or OTM, mean an options contract has no intrinsic value, only extrinsic value. 
• Out-of-the-money options are cheaper than in-the-money options because they need the underlying asset to move further to become profitable. 
• OTM call options have a higher strike price than the underlying asset. 
• OTM put options have a lower strike price than the underlying asset.

Intrinsic Value vs. Extrinsic Value

The definition of intrinsic means to possess naturally or internally. Whereas the definition of extrinsic is the opposite, to not possess internally. 

Intrinsic Value

Regarding options contracts, intrinsic value means that the contract possesses value within the contract. The intrinsic value within the contract is derived from the difference in price between the strike price and the underlying asset price. Out-of-the-money options contracts have zero intrinsic value.

Extrinsic Value

The extrinsic value of an options contract is derived from external variables such as time value (days till expiration (DTE) and implied volatility (IV). Out-of-the-money options contracts only have extrinsic value.

Why are out-of-the-money options cheaper?

Out-of-the-money options are cheaper because they only have extrinsic value. The further out of the money a strike price is, the less likely it is to have any value before it expires. Market makers who price options contracts understand that the probability of a far out-of-the-money options contract having any value at expiration is slim to none. 

Generally speaking, a trader should consider the premium paid for an OTM option contract as an indicator of its profit potential. Meaning: if a trader buys a far out-of-the-money option for a fraction of the cost, they should expect a fraction of a percentage that it will be profitable before expiration. 

In Conclusion

Out-of-the-money options have no intrinsic value. The further out-of-the-money options contracts are, the less likely they are to be profitable. They are the opposite of in-the-money options. OTM options contracts can be used in spreads to generate reliable profits. Simpler Trading has expert traders who consistently generate profits from selling out-of-the-money options are part of a specific trading strategy. If you’re interested in learning to trade for free, visit our Free Trading Room.

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