Investors use options to profit from price movements and protect against potential losses in their portfolios. However, before a🦹dding this useful tool to your investing arsena🏅l, it’s important to get to grips with how these contracts work and the jargon.

One of the key option-related terms you’ll come across is "moneyness." Options are described as “in the money,” “out of the money,” or “at the money” depending on their 澳洲幸运5开奖号码历史查询:intrinsic value at any given moment. As implied in the name, “out of the money,” the subject of this article, is an option that can’t currently be exercised for a profit.

Understanding Options: Basic Concepts

Options give you the right, but not the obligation, to buy or sell a security, such as a stock, bond, or currency, at a certain price, called the 澳洲幸运5开奖号码历史查询:strike price, by a specified date, known as the 澳洲幸运5开奖号码历史查询:expiration date.

In every transaction, there are two sides betting against each other. There’s the seller, who creates an option they hope won’t be exercised, in exchange for a fee called the premium. And there's the buyer, who pays for the option in the belief that the strike price will be exceeded, making them money.

When buying an option, you bet its price will rise above the strike price, which requires buying a call option, or that the price will fall below the strike price, which requires buying a 澳洲幸运5开奖号码历史查询:put option.

Example

Jam꧅es thinks Company ABC’s share price will rise to at least $500. Rather than buy the stock, he purchases a call optiඣon for $200, giving him the option to buy 100 shares, which currently trade at $400, for $430 within six months.

Should Company ABC rise to $500 within six month﷽s, James could exercise the option, in which case he’d buy 🍷the stock for $430 and then sell it for $500. That would net him a return of $7,000 ($70 x 100 shares), minus the $200 premium and any trading fees.

The same example can be applied the other way around. If James thought Company ABC's share price was set to fall significantly, he would buy a put option, paying a fee in exchange for the right to sell Lockheed’s shares at a specified price within the specified time frame.

For that move to be profitable, Lockheed’s share price needs to fall below the strike price offered by the options contract writer. If it did, James would exercise the option and cash in. If it didn’t, he’d walk away with a loss limited to the cost of the put option contract.

Defining 'Out of the Money' (OTM)

Deciding whether to ⭕exercise an option depends primarily on the relationship between the market price of t❀he security you’ve chosen and the strike price.

Options can be:

• In-The-Money (ITM): The strike price is favorable compared to the current market price and you could profit by exercising the option.
• At-The-Money (ATM). This means the strike price is equal to or very near the current price of the underlying asset. You wouldn’t make any real money by immediately exercising your right to buy or sell but that could change with a small price movement in your favor.
• Out-Of-The-Money (OTM). The strike price isn’t favorable and you would lose money if you exercised the option.
  

An option to buy a stock at $120 that currently trades at $100 or sell a stock at $100 that curreꦅntly trades at $120 would be deemed OTM. OTM is essentially the worst situation an investor in possession of an unexpired option can find themselves in. When an option is OTM, it currently has no intrinsic 🧸value, meaning if you exercise it now you’d lose money.

Nevertheless, OTM options may still be worth something eventually. That’s because they still possess extrinsic or 澳洲幸运5开奖号码历史查询:time value. As long as t𝔍here's still a chance the stock in the example rises above $120 or below $100, it has some value. How much depends mainly on how much time is left before the option e⛦xpires and the volatility profile of the security. The more the security is prone to price swings and the longer the time left, the better.

Characteristics of OTM Options

OTM options have several distinct characteristics. Kꦡey traits include:

• Not worth exercising now. If an OTM option is exercised now the holder will lose money because the strike price hasn't been reached.
• Time is key. OTM options aren’t without value. There is still a chance they can move into a profitable position before they expire. The further away the expiration date is the better; this means having more time to reach the objective.
• Cheaper. OTM options cost less than ITM and ATM options with the same expiration date because they can’t yet be exercised at a profit and hitting the strike price often requires a significant price move. Time is the only thing on their side.

Example of OTM Options

Matt is bullish on Company XYZ. He thinks it is undervalued at $120 a share, so buys a call option on the stock with a $150 strike price. This option expires in five months and costs $1. Each option contract represents 100 shares, so the total cost of the option is $100 (100 x $1) plus any trading fees.

Matt now has to wait. To make a profit from the trade, he must exercise the option when Company XYZ's shares trade at a minimum of $151. Obviously, the higher the share price goes, the better.

Sadly, it doesn’t work out that way. The share price experiences an initial bounce to $155, pushing the option ITM, but Matt believes more upside is in store and decides to wait. N🌠ot long after, gloomy economic data dents sentiment, causing shares to seesaw betwe🍌en $100 and $115 over the next few months.

With one month left, Matt has a few possibilities. He can sell the option, which is still worth something but less than the $100 he paid because the price is now lower and there’s little time remaining. Or he can hold on and hope the company's shares rally. He opts for the latter.

Two weeks later, Company XYZ's shares rocket to $145. Given the changing economic backdrop, Matt doubts they will rise much higher in the little time remaining but doesn’t want to lose the $100 he paid for the option. As the shares aren’t far off the strike price, Matt manages to sell the option contract for $0.90 per share, or $90, thus limiting his loss to just $10 plus trading fees.

The Bottom Line

Out of the money (OTM) options are contracts that currently have no intrinsic value because they can't currently be exercised for a profit. But they still hold value, based on their potential to turn profitable before their expiration date if the market moves in their favor. In fact, some investors prefer buying out of the money options because they're cheaper and offer a higher potential return. But out of the money options come with a lower probability of turning a profit and lose value as the expiration day approaches.