By Cory Mitchell Updated Aug 30, Out-of-the-money OTM options are more cheaply priced than in-the-money ITM or in-the-money options because the OTM options require the underlying asset to move further in order for the value of the option called the premium to substantially increase.
Out-of-the-money options are ones whereby the strike price is unfavorable when compared to the underlying stock's price.
Although OTM options are cheaper than buying the stock outright, there's an increased chance of losing the upfront premium. Since the probability is low that the stock could make such a dramatic move before the option's expiration date, the premium to buy the option is lower than those options that have a higher probability of profitability.
What looks cheap isn't always a good deal, because often things are cheap for a reason. Option delivery said, when an OTM option is properly selected and bought at the right time, it can lead to large returns, hence the allure.
The Lure of Out-of-the-Money Options Call Options A call option provides the money options the right, but not the obligation, to buy the underlying stock at the pre-set strike price before the option's expiry.
Put Options A put option provides the buyer the right, but not the obligation, to sell the underlying stock money options the pre-set strike price before the option's expiry. Put options are considered to be OTM if the strike price for the option is below the current price of the underlying security. The further out of the money an option is, the cheaper it is because it becomes more likely that underlying will not be able to reach the distant strike price.
Likewise, OTM options with a closer expiry will cost less than options with an expiry that is further out.
The Dangerous Lure of Cheap Out-of-the-Money Options
OTM options also have no intrinsic valuewhich is another big reason they are cheaper than ITM options. Intrinsic value is the profit from the difference between the stock's current price and the strike price.
- ITM thus indicates that an option has value in a strike price that is favorable in comparison to the prevailing market price of the underlying asset: An in-the-money call option means the option holder has the opportunity to buy the security below its current market price.
- Article Reviewed on July 31, Michael J Boyle Updated July 31, An option contract's value fluctuates based on the price of the asset underlying it, such as a stock, exchange-traded fund, or futures contract.
- In the Money, At the Money, Out of the Money Options - Macroption
If there is no intrinsic value, the premium of the option will be lower than those options that have intrinsic value embedded in them. If the underlying stock does move in the anticipated direction, and the OTM option eventually becomes an in-the-money option, its price will increase much more on a percentage basis than if the trader bought an ITM option at the onset.
In The Money (ITM) Definition
This clearly illustrates the effect of leverage. A trader could money options eight of these 50 strike price calls for the same cost as buying one of the 45 strike price ITM calls.
Glossary Time value of at the money vs. Zero intrinsic value Out of the money options have zero intrinsic value and their market price is equal to their time value. In this sense they are the same as at the money options. You have no intrinsic value to pay for when you are buying an out of the money option and therefore your money options risk of holding the option will be limited to its time value. Also the interest factor will be similar to at the money options — you pay less for the option, which means less interest or opportunity cost in terms of time value of money.
Notice the right side of the x-axis on the graph below. The profit numbers are significantly higher than what was seen on the previous graphs.
Glossary Moneyness of an option Moneyness is a strange sounding term, but it is sometimes used for describing the amount of intrinsic value an option has. All options belong to one of the three basic groups and they can move between these groups as the market price of the underlying changes, as you will see below. The three groups are: In the money options At the money options Out of the money options Shortcuts are frequently used for these terms and they are also used here on Macroption. In the money options An option is in the money if its intrinsic value is greater than zero probably the most important sentence of this article, money options it once again.
This price is 6. So to put it another way, if the stock does anything less than rally more than 6.
In the Money (ITM)
Comparing Potential Risks and Rewards The following chart displays the relevant data for each of the three positions, including the expected profit—in dollars and percent. Such a large swing is often unrealistic for a short time period unless a major market or corporate event occurs.
This is despite the fact that she was correct in her forecast money options the stock would rise, it just didn't rise enough. However, it's important to first understand the unique risks involved in any position.
It's also important to consider alternatives that might offer a better tradeoff between profitability and probability.
In The Money Options (ITM Options)
These graphs are just examples of profit and loss potential for various scenarios. Each trade money options different, and option prices are constantly changing as the price of the other underlying and other variables change.
Article Sources Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.
We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Securities and Exchange Commission. Compare Accounts.