Underwater Options

Underwater options (also known as 'out-of-the-money options') are financial contracts that have, for the moment, lost their sparkle. Simply put, an option is “underwater” when exercising it would result in a financial loss. For a call option—the right to buy an asset at a set price—this happens when the asset's current market price is below the option's strike price (the set price). You wouldn't want to use your option to buy a stock for $50 if it's selling for $40 on the open market! Conversely, for a put option—the right to sell an asset at a set price—it's underwater when the market price is above the strike price. Why use your option to sell for $50 when you could get $60 for it? At that specific moment, an underwater option has no intrinsic value. It's a ticket to a game that's currently a blowout, but that doesn't mean the final score is in just yet.

Imagine you're a treasure diver. Your contract (the option) gives you the right to retrieve a treasure chest (the stock) from a shipwreck at a depth of 50 meters (the strike price). If the treasure chest is actually resting at 60 meters deep (the market price is unfavorable), your contract is “underwater”—it's currently useless. Let's put this in market terms:

• Example of an Underwater Call Option:
  1. You buy a call option for “Innovate Corp.” with a strike price of $100, expiring in three months.
  2. Innovate Corp. stock is currently trading at $90.
  3. Your option is $10 underwater ($100 strike price - $90 market price). Exercising it would mean paying $10 more than the stock's market value. It's a losing proposition right now.
• Example of an Underwater Put Option:
  1. You buy a put option for “Steady Eddies Inc.” with a strike price of $40, expiring in three months.
  2. Steady Eddies' stock is currently trading at $45.
  3. Your option is $5 underwater ($45 market price - $40 strike price). You wouldn't exercise your right to sell at $40 when the market is willing to pay you $45.

If these options are currently worthless, why does anyone hold them? The answer lies in one of the most powerful forces in finance: time.

An option has two components of value: intrinsic value (the immediate profit from exercising) and extrinsic value (also known as time value). An underwater option has zero intrinsic value, but it can still have significant extrinsic value. This value represents the possibility—the hope—that the price of the underlying asset will move in your favor before the expiration date. A stock's volatility plays a huge role here. The more a stock's price swings, the greater the chance it could move enough to make your underwater option profitable (or in-the-money) before it expires. The holder is essentially paying for time and the possibility of a comeback.

One of the most common places you'll hear this term is in the context of ESOs (Employee Stock Options). Companies often grant these to employees as a form of long-term incentive, with a strike price equal to the stock's market price on the grant date. If the company's stock price falls, these ESOs become underwater. This can be a major blow to employee morale, as a key part of their potential compensation has seemingly vanished. A large volume of underwater ESOs on a company's books can be a red flag, indicating poor stock performance and potentially leading to management headaches, such as controversially choosing to reprice options.

For a disciple of value investing, options are often viewed with a healthy dose of skepticism. The philosophy, pioneered by figures like Benjamin Graham and popularized by Warren Buffett, centers on buying wonderful businesses at fair prices, not on speculating on short-term price movements.

• Speculation, Not Investment: Buying an underwater call option is a purely speculative bet that a stock's price will rise significantly in a short period. It has nothing to do with analyzing a company's long-term earning power or balance sheet. It is a bet on price, not value.
• Zero Margin of Safety: An underwater option has no intrinsic value and thus zero margin of safety. If the hoped-for price movement doesn't happen by expiration, the entire premium paid for the option is lost. This is the polar opposite of the value investor's goal to protect principal.
• A Tool, Not a Treasure: While most value investors avoid buying speculative options, understanding them is crucial. Some sophisticated investors may sell options (e.g., writing covered calls) to generate income from stocks they already own. However, chasing lottery-ticket-like returns from underwater options is fundamentally at odds with the patient, business-focused approach of value investing.