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.
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Out-of-the-money options are ones whereby the strike price is unfavorable when compared to the underlying stock's price.
The further out of the money an option is, the cheaper it is because it becomes less likely that underlying will reach the distant strike price.
The Dangerous Lure of Cheap out of the Money Options
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.
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What looks cheap isn't always a good deal, because often things are cheap for a reason. That 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 Options from 100 per day call option provides the buyer 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 at 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. 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.
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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.
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This clearly illustrates the effect of leverage. A trader could purchase eight of these 50 strike price calls for the same cost as buying one of the 45 options from 100 per day price ITM calls.
The Dangerous Lure of Cheap Out-of-the-Money Options
Notice the right side the option is emission the x-axis on the graph below. The profit numbers are significantly higher than what was seen on the previous graphs.
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This price is 6. So to put it another way, if the stock does anything less than rally more than 6.
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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 that 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.
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These graphs are just examples of profit and loss potential for various scenarios. Each trade is 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.
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