Out-of-the-Money (OTM)

An “Out-of-the-Money” (OTM) option is one that currently holds no intrinsic value. Think of it as a ticket to a game that hasn't started yet; its immediate value is zero, but you're holding it in hopes of a future win. If an OTM option were to expire at this very moment, it would be completely worthless. Its entire market price is derived from its extrinsic value (also known as time value), which is the premium buyers are willing to pay for the possibility that the option might become profitable before it expires. The further an option is OTM, the cheaper it is, but also the less likely it is to ever become profitable. For the two main types of options, the OTM condition is a simple mirror image:

• A call option, which gives the right to buy a stock, is OTM when the stock's current market price is below the option's strike price.
• A put option, which gives the right to sell a stock, is OTM when the stock's current market price is above the option's strike price.

Understanding OTM is crucial because it helps you grasp the risk and reward of an options contract. OTM options are the cheapest of the three “moneyness” states, making them alluring for speculators who want to make a leveraged bet with a small amount of capital. The three states of “moneyness” are:

• Out-of-the-Money (OTM): The option has no intrinsic value. It's a pure bet on future price movement.
• At-the-Money (ATM): The stock price is equal (or very close) to the strike price.
• In-the-Money (ITM): The option has intrinsic value. It would be profitable if exercised immediately (before accounting for the premium paid).

Because OTM options are cheaper, they offer the potential for higher percentage returns if you guess the direction and magnitude of a stock's move correctly. However, they also carry the highest probability of expiring worthless, meaning you lose your entire investment.

Let's see OTM in action with a couple of real-world scenarios.

Imagine shares of Apple Inc. (AAPL) are trading at $170. You are bullish and believe the stock is about to surge. You look at the options market and see a call option with a strike price of $180 that expires in one month. This $180 call option is OTM because the strike price ($180) is higher than the current stock price ($170). Exercising it now would mean paying $180 for a stock you could buy on the open market for $170—a guaranteed loss. You buy this cheap OTM option hoping that AAPL's price will climb above $180 before your month is up, turning your speculative bet into a winner.

Now, let's say shares of Tesla, Inc. (TSLA) are trading at $250. You're feeling bearish and think the stock is overvalued. You find a put option with a strike price of $230 that expires in two months. This $230 put option is OTM because the strike price ($230) is lower than the current stock price ($250). Why would you want the right to sell a stock for $230 when it's currently worth $250? You wouldn't—not yet. You're buying this OTM put as a bet that TSLA's price will fall below $230, making your right to sell at that higher price suddenly very valuable.

For a value investor, buying OTM options is generally viewed with extreme skepticism. The practice is much closer to gambling than it is to investing. The core philosophy of value investing, championed by figures like Warren Buffett, is to buy wonderful businesses at fair prices and hold them for the long term. This strategy is about minimizing risk by understanding the true value of an asset. Buying OTM options is the polar opposite. It is a high-risk, short-term speculation that relies on correctly predicting market sentiment and timing. The biggest enemy of the OTM option buyer is time decay (also known by its Greek letter, “theta”). Every day that passes, an OTM option's extrinsic value erodes, making it a race against a ticking clock. If the stock price doesn't move favorably and quickly enough, the option will expire worthless. While some advanced investors use strategies that involve selling OTM options to generate income (e.g., selling covered calls on stocks they already own), the act of buying them is a speculative venture that most value investors wisely avoid. It's a game where the odds are heavily stacked against the buyer.