Understanding Out of the Money (OTM) options can give traders a sharper edge in the market. These options often seem risky due to their lower probability of finishing in the money, but they serve crucial roles in speculation, hedging, and cost-efficient trading strategies. Knowing when and how to use them can improve decision-making and risk management.
OTM Meaning in Options Trading
An option is considered Out of the Money (OTM) when it has no intrinsic value—meaning the underlying asset’s price is unfavorable for immediate exercise. Traders use OTM options for speculative bets, leveraging small investments for potentially large gains.
OTM options contrast with In the Money (ITM) and At the Money (ATM) options in key ways:
How OTM Differs from ITM and ATM
- OTM Options: Have no intrinsic value, only extrinsic (time) value. These options are cheaper but require a significant price movement to become profitable.
- ITM Options: Contain intrinsic value because the strike price is favorable compared to the underlying asset’s price. They are more expensive but have a higher probability of profitability.
- ATM Options: The strike price is nearly equal to the underlying asset’s current market price, balancing cost and risk.
| Option Type | Intrinsic Value | Cost | Probability of Profit |
| OTM | None | Low | Low |
| ATM | Minimal | Medium | Moderate |
| ITM | High | Expensive | High |
Why Options Go Out of the Money
Several factors cause an option to move OTM:
- Price Movements: If a stock or asset moves against the option’s strike price, it loses intrinsic value.
- Time Decay (Theta): As expiration nears, OTM options lose extrinsic value rapidly.
- Volatility Drops: Lower implied volatility reduces an option’s premium, making it harder to reach profitability.
- Market Sentiment Shifts: Unexpected news or sentiment changes can make an option less likely to end in the money.
OTM Call and Put Options Explained
Out of the Money (OTM) status applies to both call options and put options, but in different ways. A call option is OTM when the strike price is higher than the current market price of the underlying asset. A put option is OTM when the strike price is lower than the asset’s market price.
Since neither has intrinsic value, their worth is purely based on time until expiration and implied volatility. Understanding how each works helps traders navigate risks and potential opportunities.
OTM Call Option Example
Imagine a trader buys a call option on Apple (AAPL) stock with a strike price of $200, but AAPL is currently trading at $190.
- Since the stock price is below the strike price, the option has no intrinsic value and is considered OTM.
- The option’s price is based solely on its extrinsic value, influenced by time and volatility.
- If AAPL’s price remains below $200 at expiration, the option expires worthless.
However, if AAPL rallies above $200 before expiration, the option moves closer to At the Money (ATM) and then In the Money (ITM), increasing in value.
OTM Put Option Example
Now, consider a trader who buys a put option on Tesla (TSLA) stock with a strike price of $150, but TSLA is currently trading at $160.
- Since the stock price is above the strike price, the put option has no intrinsic value and is OTM.
- Like OTM calls, this put option’s value depends on time and volatility.
- If TSLA stays above $150, the option will expire worthless.
But if TSLA drops below $150, the put option gains intrinsic value, increasing its worth. Traders use OTM puts for downside speculation or hedging against stock declines.
Why Traders Use OTM Options
Despite their higher risk of expiring worthless, traders frequently use Out of the Money (OTM) options for strategic purposes. The lower cost and potential for high returns make them appealing for speculation, while their flexibility allows for hedging against market movements.
Lower Cost Compared to ITM Options
One of the main reasons traders favor OTM options is their affordability. Since these options have no intrinsic value, their premiums are significantly lower than ITM options.
- Lower Initial Investment: A trader can control a large position with minimal capital.
- Defined Risk: The maximum loss is the premium paid, making risk predictable.
- Leverage Opportunities: A small price movement in the underlying asset can lead to substantial percentage gains.
For example, if an ITM call option costs $5.00 per contract, an OTM call on the same stock might cost $1.00 per contract, allowing traders to enter more positions for the same cost.
Potential for High Returns
OTM options carry higher risk but also greater reward potential. While many expire worthless, those that do move into the money can offer substantial percentage gains.
- A small investment can generate outsized returns if the underlying asset moves significantly in the right direction.
- OTM options benefit from increased volatility, which can boost premiums before expiration.
- Large price swings in stocks, commodities, or forex pairs can make OTM options highly profitable.
For example, a trader buys an OTM call option for $1.00. If the stock rallies and the option moves ITM, its value might surge to $5.00, a 400% return—far higher than the percentage gains in the underlying asset.
Speculative and Hedging Use Cases
OTM options serve two main purposes: speculation and hedging.
- Speculation: Traders use OTM options to bet on significant price moves without committing large amounts of capital.
- Hedging: Investors use OTM options as insurance to protect portfolios against adverse movements.
For example:
- A trader expecting a major earnings surprise might buy an OTM call or put.
- A portfolio manager holding a large tech stock position could buy OTM put options to hedge against a downturn.
The combination of low cost, high potential returns, and strategic flexibility makes OTM options a key tool in many traders’ arsenals.
Risks and Limitations of OTM Options
Out-of-the-money (OTM) options can offer high potential returns, but they come with significant risks. Many traders are drawn to them due to their lower cost compared to in-the-money (ITM) or at-the-money (ATM) options, but these contracts often expire worthless unless the underlying asset experiences substantial price movement.
High Chance of Expiring Worthless
One of the biggest risks is that most OTM options never reach profitability. Because they require the underlying asset to move beyond the strike price before expiration, many contracts fail to gain intrinsic value and expire with no payout. Studies show that a large percentage of OTM options expire worthless, making them a risky bet for traders who don’t have a strong directional bias or market insight.
Limited Probability of Profit
For an OTM option to become profitable, the price of the underlying asset must move significantly in a relatively short period. This is particularly challenging in low-volatility markets. The further OTM an option is, the greater the movement required, reducing the likelihood of profitability. Even when prices move favorably, OTM options may not gain enough value due to factors like implied volatility shifts.
Impact of Time Decay on OTM Options
Time decay (theta) is a major factor working against OTM options. As expiration approaches, the extrinsic value of the option diminishes rapidly. If the underlying asset’s price doesn’t move quickly enough, traders may see their option lose value even if they were correct about the general market direction. Since OTM options have no intrinsic value, they are entirely dependent on time and volatility for their worth.
What Happens to OTM Options at Expiration?
When an OTM option reaches expiration, it generally becomes worthless because it holds no intrinsic value. Unlike ITM options, which may be automatically exercised, OTM options do not provide any financial benefit at expiration.
Do Brokers Automatically Exercise OTM Options?
No, brokers do not exercise OTM options since they have no intrinsic value. If a trader holds an OTM option at expiration, it simply expires, and they lose the entire premium paid. Some brokers automatically remove expired options from the account, while others may require manual closure before expiration.
How to Exit an OTM Trade Before Expiration
Traders can manage OTM options by:
- Closing the position early: Selling the option before expiration can recover some premium, especially if volatility increases.
- Rolling the option: Extending the trade by rolling into a later expiration date can provide more time for a favorable price move.
- Using stop-loss strategies: Setting exit points based on percentage loss limits can help manage risk.
Trading Strategies for OTM Options
Despite their risks, OTM options play a role in various trading strategies, particularly for speculation and income generation.
Buying OTM Calls and Puts for Speculation
Traders use OTM options when betting on strong price movements. These contracts offer a high-reward potential with a limited loss (premium paid). However, success relies on accurate timing and volatility. OTM calls are popular in bull markets, while OTM puts are used for bearish bets or hedging.
Selling OTM Options for Income (Options Writing)
Writing OTM options is a strategy used to collect premiums with a high probability of expiration without being exercised. Some common approaches include:
- Covered calls: Selling OTM calls against owned stock to generate income while maintaining the underlying asset.
- Cash-secured puts: Selling OTM puts to collect premiums while potentially buying stock at a lower price.
This approach benefits from time decay but carries the risk of assignment if the asset moves against the trader’s position.
Spreads and Multi-Leg Strategies Using OTM Options
OTM options can be used in spreads to balance risk and reward. Some examples include:
- Credit spreads: Selling OTM options while buying further OTM options to cap risk.
- Debit spreads: Using OTM options to reduce cost while maintaining upside potential.
- Iron condors: Selling both OTM puts and calls to profit from low volatility.
Choosing Between ITM, ATM, and OTM Options
Selecting the right option depends on a trader’s strategy, risk tolerance, and market outlook.
When to Trade OTM vs. ITM Options
- OTM options: Best for traders looking for high-reward, low-cost speculation but willing to accept a lower probability of success.
- ITM options: Offer higher delta, meaning a greater chance of profit, but come with a higher premium.
- ATM options: Strike a balance between cost and probability of profitability.
Market Conditions Favoring OTM Options
Certain conditions make OTM options more attractive:
- High volatility: When implied volatility is high, OTM options can increase in value quickly.
- Event-driven trading: Earnings reports or major economic releases can cause sharp moves, making OTM options appealing.
- Strong trends: OTM options benefit from momentum-driven markets where prices are likely to make significant moves.
Adjusting Strike Prices for Better Risk-Reward
Choosing the right strike price is crucial. Traders often:
- Use near-OTM strikes for a higher chance of profit.
- Go further OTM for cheaper contracts but lower probability of success.
- Adjust strikes based on implied volatility and expected price movement.
Conclusion: Are OTM Options Worth Trading?
OTM options provide opportunities for traders with a strong market view, but their risks should not be overlooked. They can be a cost-effective way to speculate or hedge but require careful management due to time decay and low probability of profit.
Best Ways to Trade OTM Without High Risk
- Use defined-risk strategies: Spreads and hedging help limit losses.
- Manage position sizing: Risking only a small percentage of capital on OTM trades prevents large drawdowns.
- Monitor volatility: Trading OTM options in volatile markets can improve chances of profitability.
Common Mistakes to Avoid When Trading OTM
- Ignoring time decay: Many traders hold OTM options too long, losing value rapidly.
- Overleveraging: Buying too many OTM contracts can lead to quick losses.
- Misjudging volatility: Low IV environments make OTM options less effective.
- Failing to exit early: Taking profits on price swings rather than holding to expiration increases success rates.
