Updated July 15, 2023
Definition of Out of the Money
The term “out of the money” refers to the option contract with only time value and no intrinsic value. For instance, a call option refers to out of the money if the open market price of the underlying asset is lower than the option’s strike price.
In comparison, a put option refers to being out of the money if the open market price of the underlying asset is higher than the option’s strike price.
Explanation
An option contract’s value largely depends on its strike price and the open market price of the underlying asset, such as stock, commodity, ETF, etc. An option can be in the money, at the money, or out of the money based on the relationship between its strike price and the underlying asset’s market price. It means that the underlying asset’s market price hasn’t reached the option’s strike price yet, and if the holder exercises it now, then he/ she will lose money. On the other hand, if an option expires, then the money lost, in this case, is simply the premium paid for buying the option.
Why Buy Out of the Money?
It is important to understand that if an option is currently out of the money, it doesn’t mean the trader can’t make a profit in the future. The cost is relatively cheap as it has no intrinsic value. However, a trader purchases this option if he/she believes that the underlying asset is currently mispriced and expects to correct it in the near future. If the underlying asset’s price moves as per the expectation of the trader, then he/ she can earn much more than in the money or at the money option owing to its cheaper price.
Example
Now, let us look at some examples to understand how this works.
Example #1
Let us take the example of a company stock currently trading at $200 per share. Now, a trader purchases a call option at a strike price of $250, expecting the stock to go up to $300 per share. So, the call option is currently out of the money as the strike price ($250) of the call option is higher than the underlying stock price ($200). But, if the stock price reaches $300 per share, the option will soon become money.
Example #2
Let us take the example of another company stock currently trading at $80 per share. However, there is news that it incurred a major loss in one of its ongoing projects, and hence the stock price may go down as much as $50 per share. Based on the market sentiment, a trader purchases a put option at a strike price of $ 70. So, the put option is currently out of the money as the strike price ($70) of the put option is lower than the underlying stock price ($80). But, if the stock price crashes to $50 per share, the option will soon turn into money.
When is Call Option Out of the Money?
A call option refers to being out of the money when the option’s strike price is higher than the current open market price of the underlying asset. The option holder has the right to purchase the underlying asset at a price higher than the prevalent asset price, so it has zero intrinsic value. This type of call option can only gain in value if the price of the underlying assets rallies above the strike price of the option.
When is Put Option Out of the Money?
When the option’s strike price is lower than the current open market price of the underlying asset, it is called a Put Option. The option holder has the right to sell the underlying asset at a price lower than the prevalent asset price, which doesn’t make any economic sense. In this case, the put option can gain in value if the price of the underlying assets plummets to go below the option’s strike price.
Advantages
- The same price movement in the underlying asset can offer a higher percentage gain than in the money or at-the-money options.
- Since it has no intrinsic value, its price is cheaper(in absolute dollar terms) than in the money or at-the-money options.
Disadvantages
- The option holder loses all the money spent on purchasing it if it expires.
- Such options require the underlying asset’s price to move significantly to make a profit, which exposes it to a higher risk of losing money than in the money or at-the-money options.
Conclusion
So, it can be seen that the money option can generate the highest percentage gain if the prediction about the price movement of the underlying asset goes right. However, it can result in a loss if the prediction goes wrong. So, it is suitable only for seasoned traders as it requires the acumen to judge the market perfectly.
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