What is Out of the Money (OTM) in Options Trading?
Options trading, isn’t it just a maze sometimes? You hear terms like “in the money,” “at the money,” and then there’s “out of the money.” If you’ve ever felt a bit lost trying to grasp what “out of the money” (OTM) truly means and why it matters in the world of options, you’re not alone. Believe me, in my journey through financial markets, I’ve seen countless folks grapple with these distinctions. But once you get it, a whole new layer of strategic trading opens up.
Think of it like this: an option gives you the right, but not the obligation, to buy or sell an asset at a specific price (the strike price) before a certain date (expiration). The “money-ness” of an option simply describes its relationship between that strike price and the current market price of the underlying asset. And when we talk OTM, we’re discussing options that, at this very moment, hold no intrinsic value. They’re basically hoping for a future shift in the stock price to become valuable.
Let’s break down OTM for both calls and puts, because they operate on opposite sides of the market coin.
Imagine you’re buying a call option. You’re betting the stock price will go up. A call option is considered Out Of The Money (OTM) if its strike price is higher than the current market price of the underlying asset.
- Example: If a stock is trading at $100 and you buy a call option with a strike price of $105, that call option is OTM. Why? Because you wouldn’t exercise your right to buy at $105 when you could simply buy the stock in the open market for $100. It makes no sense, right? For this option to become “in the money” (ITM), the stock price would need to rise above $105.
Now, let’s flip it to put options. You’re betting the stock price will go down. A put option is considered Out Of The Money (OTM) if its strike price is lower than the current market price of the underlying asset.
- Example: Same stock, trading at $100. If you buy a put option with a strike price of $95, that put option is OTM. You wouldn’t exercise your right to sell at $95 when you could sell the stock in the open market for $100. For this put option to become ITM, the stock price would need to fall below $95.
See the pattern? For an OTM option to gain intrinsic value, the market price needs to cross its strike price. Until then, its value is purely time value and implied volatility.
It might seem counterintuitive to buy something that currently has no intrinsic value, but there are several strategic reasons why OTM options are a popular choice for traders. And yes, from my observations, these strategies often revolve around leveraging perceived low cost for potentially high reward or for generating income.
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Lower Premiums for Buyers:
- One of the most appealing aspects for buyers of OTM options is their price tag. OTM options are generally cheaper than their “at the money” (ATM) or “in the money” (ITM) counterparts. Why? Because the probability of them expiring in the money is lower. This lower cost means you can control more shares for the same amount of capital, offering higher leverage if your directional bet pays off.
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Income Generation for Sellers:
- This is where OTM options truly shine for certain strategies, especially for those looking to generate consistent income. Selling OTM options (also known as “writing” options) allows you to collect premium upfront. The hope is that the option will expire worthless, allowing you to keep the entire premium.
- Consider the strategy of selling short Out Of The Money (OTM) put options. As Mark Hake, CFA, noted, investors could make over a 2.0% monthly yield by selling short 6% OTM put options on Amazon (AMZN) when its stock was at $220.18 on Tuesday, July 8, 2025 (TalkMarkets, “Amazon Stock Bargain”). Similarly, he highlighted that selling short OTM put options expiring in just over one month could provide investors a 1.67% monthly yield on Chevron (CVX), given CVX’s closing price of $148.37 on July 3, 2025 (Dummersgrain, “Chevron Stock’s Dividend Yield”). This strategy appeals to those who are bullish or neutral on a stock and believe it won’t drop below the chosen OTM strike price before expiration.
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Speculative Plays:
- If you have a strong conviction about a sudden, significant move in a stock, OTM options can offer outsized returns. A small premium paid could explode in value if the stock makes a big move in your favor, turning your OTM option into ITM. It’s a high-risk, high-reward game, akin to hitting a grand slam in baseball – rare, but impactful when it happens.
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Portfolio Hedging (Less Common for Pure OTM):
- While more often associated with ITM or ATM options, OTM options can, in some niche scenarios, serve as very cheap “disaster insurance.” However, due to their distance from the current price, they offer less robust protection than closer strikes.
Now, it’s not all sunshine and high yields. OTM options come with their own set of risks and it’s crucial to understand them before diving in.
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Time Decay (Theta):
- This is perhaps the biggest enemy of OTM option buyers. Every day that passes, an OTM option loses value, even if the stock price doesn’t move. The closer you get to expiration, the faster this time value erodes. If an OTM option doesn’t become ITM before expiration, it expires worthless. This is why sellers of OTM options love time decay!
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Lower Probability of Success for Buyers:
- By definition, OTM options are “out of the money” because they are less likely to end up ITM. You’re betting on a larger price move in your favor. This means a higher probability of losing the entire premium paid if the stock doesn’t move as expected.
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Unlimited Risk for Naked OTM Sellers (Puts):
- While selling OTM puts can generate income, remember that if the stock crashes below your chosen strike price, you could be obligated to buy shares at a much higher price than their current market value. This risk is theoretically unlimited for naked options (those not covered by holding the underlying asset).
How are funds actually structuring their options positions with OTM options? We can glean some insights from how a fund like Purpose Investments’ Premium Yield Fund (PYF) allocates its written put options. As of July 7, 2025, a significant portion of their short put options were OTM, demonstrating a strategic tilt towards income generation from these types of contracts (Purpose Investments, “Premium Yield Fund”).
Let’s look at their breakdown:
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Short Puts Expiring <1 mo:
- 93.48% (a strong preference for short-dated options, which decay faster).
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Short Puts Expiring 1-3 mo:
- 6.52%
And the “money-ness” breakdown of their written put options as of July 7, 2025:
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In the Money (ITM):
- 0.00% (No ITM puts written, which makes sense for an income-focused fund avoiding immediate assignment risk).
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At the Money (ATM):
- 11.02%
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Out of the Money (OTM):
- <-4%: 23.79% (These are OTM puts where the strike price is at least 4% below the current market price).
- <-8%: 12.56% (Even further OTM, indicating a belief the stock won’t drop that far).
- <-12%: 52.63% (A whopping majority are deep OTM, suggesting a strategy focused on collecting premiums with a high probability of expiry worthless.)
This kind of data provides a real-world example of how a fund structures its positions, leveraging the time decay and lower risk for the seller inherent in OTM options, especially deep OTM ones, for yield generation. It’s a testament to the fact that while OTM options are risky for buyers, they can be quite appealing for sellers who prioritize probability over massive, speculative gains.
Understanding Out Of The Money options is more than just knowing a definition; it’s about recognizing a powerful tool in the options trading arsenal. Whether you’re a buyer seeking high leverage for a speculative bet or a seller aiming for consistent income, OTM options play a pivotal role. Just remember, like any financial instrument, they come with risks. Always weigh the potential rewards against the probability of success and the potential for loss. For me, the key has always been about understanding the probability involved and managing risk. Don’t chase the big win without understanding the underlying mechanics, especially when dealing with the nuanced world of OTM contracts.
References
What does 'out of the money' mean in options trading?
Out of the money (OTM) options are those that currently hold no intrinsic value, meaning their strike price is not favorable compared to the current market price.
Why do traders buy out of the money options?
Traders buy OTM options for lower premiums, potential high rewards and income generation strategies, despite the risks involved.