out_of_the_money [CapiPedia]

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======Out-of-the-Money (OTM)======
Imagine holding a coupon that lets you buy a brand-new car for $50,000, but the dealership is currently selling the exact same car for $45,000. Your coupon is effectively useless, right? In the world of finance, this is the essence of an option being "Out-of-the-Money" (OTM). An OTM [[option]] is one where exercising it immediately would result in a financial loss. For a [[call option]] (which gives you the right to //buy// an asset), it's OTM when its [[strike price]] is higher than the current market price of the [[underlying asset]]. For a [[put option]] (which gives you the right to //sell// an asset), it's OTM when its strike price is lower than the asset's market price. The most critical thing to remember is that an OTM option has zero [[intrinsic value]]. Its entire price (or [[premium]]) is composed of [[extrinsic value]], often called [[time value]]. This value represents the market's hope that the asset's price will move favorably before the option expires, turning that useless coupon into a golden ticket.
===== A Tale of Two Options: Calls and Puts =====
Understanding OTM is easiest with a couple of clear scenarios. The logic is different for calls and puts because they represent opposite desires: the desire to buy low versus the desire to sell high.
==== Call Options: Hoping for a Rocket Ship ====
A call option is a bet that an asset's price will rise. It's OTM if exercising it would mean overpaying.
  * **Example:** You buy a call option for "GrowthCo" stock with a strike price of $100, and the option expires in one month. The stock is currently trading at $90.
  * **Status:** Your option is **OTM**. Why would you use your option to buy the stock for $100 when you could simply buy it on the open market for $90? For your option to have any intrinsic value (to be [[in-the-money]]), the stock price needs to climb above $100.
==== Put Options: Preparing for a Parachute ====
A put option is a bet that an asset's price will fall. It's OTM if exercising it would mean selling for less than you could on the market.
  * **Example:** You buy a put option for "StableCorp" stock with a strike price of $40, expiring in one month. The stock is currently trading at $50.
  * **Status:** Your option is **OTM**. It makes no sense to use your option to sell the stock for $40 when the market is ready to give you $50 for it. For this put to be profitable, the stock price must fall below $40.
===== The Allure of the OTM Lottery Ticket =====
If OTM options are "useless" at the current moment, why does anyone buy them? The answer lies in their low cost and high potential payoff, which appeals to speculators and hedgers alike.
==== High-Octane Leverage ====
OTM options are cheap, and this cheapness creates massive [[leverage]]. A small investment can control a large amount of stock, and a favorable price move can lead to explosive percentage gains. Imagine an OTM call option costs just $0.25 per share ($25 for a contract of 100 shares). If good news sends the stock soaring and the option's price jumps to $1.00, the holder has made a 300% return. Of course, this is a double-edged sword. Most OTM options expire worthless, meaning the buyer loses 100% of their investment. It's a high-risk gamble that is more akin to buying a lottery ticket than making a sound investment.
==== A Cheap Insurance Policy ====
A more practical use for OTM options is [[hedging]]. Let's say you own 100 shares of a company you love, but you're worried about a potential market downturn in the next few months. You could buy an OTM put option. This acts as an insurance policy. If the stock price tumbles, the value of your put option will soar, offsetting some of the losses on your shares. It's a way to protect your portfolio from a catastrophic drop for a relatively small premium. You hope you never need it, but it provides valuable peace of mind.
===== The Prudent Investor's View =====
[[Warren Buffett]] famously labeled [[derivatives]] as "financial weapons of mass destruction." From a value investing standpoint, //buying// OTM options is usually seen as pure speculation, not investing. An investment is the purchase of a piece of a business at a rational price. An OTM option's price is based not on the business's value but on hope and time. This time value is constantly eroded by a concept known as [[theta decay]], which relentlessly pushes the option's price toward zero as expiration approaches. Therefore, buying an OTM option is a race against a ticking clock—a bet on //when// a price will move, not on //what// a business is fundamentally worth.
==== A Cunning Strategy: Selling OTM Options ====
While buying OTM options is speculative, //selling// them can be a brilliant value investing strategy. When a prudent investor sells an OTM put, they are getting paid to do something they wanted to do anyway: buy a wonderful business at an attractive price. This is known as a [[cash-secured put]].
  * **The Goal:** You've analyzed "Durable Inc." and determined you'd love to own it at $45 a share, but it currently trades at $50.
  * **The Action:** You sell a put option with a $45 strike price and collect a premium, say $1.50 per share ($150 per contract).
  * **The Outcomes:**
    - **Scenario 1:** The stock stays above $45. The option expires worthless. The buyer is out of luck, but you simply keep the $150 premium as pure profit. You got paid to be patient.
    - **Scenario 2:** The stock falls below $45. The option is exercised, and you are obligated to buy 100 shares at $45 each. However, since you received a $150 premium, your effective cost basis is $43.50 per share ($45 - $1.50). You just bought a great company at a price even lower than you had originally hoped for.
This powerful technique transforms options from a gambler's tool into an investor's ally, allowing you to generate income and build positions in quality companies with discipline and a margin of safety.