What is ‘Out of the Money’ in options trading?
In the world of options trading, the term ‘Out of the Money’ (OTM) refers to the relationship between the underlying asset’s current price and its strike price. It is one of three key terms used to describe an option’s ‘moneyness.’ The other two terms are ‘In the Money’ (ITM) and ‘At the Money’ (ATM).
To put it simply, ‘Out of the Money’ means that the option has not yet reached the strike price, making it currently unprofitable to exercise. Understanding whether an option is OTM, ITM, or ATM is crucial for traders, as it helps them make informed decisions about their trading strategies.
How does ‘Out of the Money’ work for call options?
A call option represents a bet that the underlying asset’s price will increase. When you hold a call option, you gain the right to purchase the asset at a predetermined strike price. However, if the asset’s current market price is still below the strike price, the call option is considered ‘Out of the Money.’
For example, let’s say the Australia 200 index is currently trading at 5300, and you believe its price will rise. You decide to take a call option with a strike price of 6000. As long as the Australia 200 remains below 6000, your option is OTM and cannot be exercised profitably.
How does ‘Out of the Money’ work for put options?
A put option, on the other hand, is a bet that the underlying asset’s price will decrease. It gives you the right to sell the asset at a predetermined strike price. If the asset’s current market price is above the strike price, the put option is considered ‘Out of the Money.’
For instance, if you hold a put option with a strike price of 5000 and the current market price of the asset is 5300, your option is OTM. In this scenario, exercising the option would not be profitable because you could sell the asset at a higher price in the open market.
What are the implications of ‘Out of the Money’ options?
‘Out of the Money’ options have several important implications for traders. Firstly, these options are typically cheaper than ‘In the Money’ options because they are less likely to be exercised profitably. This lower cost makes them an attractive choice for traders who believe the market will move in their favor before the option expires.
However, it’s important to note that OTM options come with a higher risk. Since the option needs a significant price movement to become profitable, traders must carefully consider their market predictions and risk tolerance. OTM options can expire worthless if the underlying asset does not reach the strike price by the expiration date.
How to use ‘Out of the Money’ options in trading strategies?
Traders often use ‘Out of the Money’ options as part of various trading strategies. One common approach is to buy OTM call options when expecting a significant upward movement in the underlying asset’s price. This strategy allows traders to leverage their investment while limiting their potential loss to the premium paid for the option.
Similarly, traders may buy OTM put options if they anticipate a substantial decline in the asset’s price. This strategy can be particularly useful during market downturns or when hedging against potential losses in other investments.
Another popular strategy involves selling OTM options, known as writing options. By selling OTM call or put options, traders can collect premiums from buyers who believe the asset will move significantly before the option expires. While this strategy can generate income, it carries the risk of substantial losses if the market moves unexpectedly.
What are some real-life examples of ‘Out of the Money’ options?
Let’s consider a real-life example to illustrate the concept of ‘Out of the Money’ options. Suppose an investor believes that the stock of Company XYZ, currently trading at $50 per share, will rise significantly in the next few months. The investor purchases a call option with a strike price of $70, which is OTM because the stock is still below $70.
Over the next few months, if Company XYZ’s stock rises to $80, the call option becomes ‘In the Money,’ and the investor can exercise the option to buy the stock at the lower strike price of $70, realizing a profit. Conversely, if the stock remains below $70, the option stays OTM and expires worthless.
Similarly, let’s say another investor expects a significant drop in the price of Company ABC’s stock, currently trading at $100 per share. The investor buys a put option with a strike price of $80, which is OTM because the stock price is above $80. If the stock falls to $60, the put option becomes ‘In the Money,’ allowing the investor to sell the stock at the higher strike price of $80. If the stock price remains above $80, the option expires worthless.
Conclusion: Why understanding ‘Out of the Money’ is essential for newbie traders?
For those new to options trading, understanding the concept of ‘Out of the Money’ is essential for making informed trading decisions. By grasping how OTM options work, traders can better evaluate their potential risks and rewards, develop effective trading strategies, and improve their chances of success in the market.
Whether you are buying or selling OTM options, it’s crucial to stay informed about market trends, conduct thorough research, and always consider your risk tolerance. With practice and experience, you can master the art of options trading and make the most of the opportunities it offers.
