Out of the Money Option
Out of the money (OTM) option is an option that has zero intrinsic value and the holder of such an option is better off letting the option expire worthless.
An out of money call option has exercise price higher than the price of the underlying asset. The holder of a call option is interested in buying the underlying asset. If he can buy it in the market at a price lower than the price offered under the option contract, he will prefer to buy the asset in the market instead of exercising the option contract and paying the higher price.
An out of the money put option has exercise price lower than the price of the underlying asset. The holder of a put option is interested in selling the underlying asset. If he can sell the asset in market at a price that is higher than the price promised by the option contract, why would he exercise the option and sell his asset at lower (exercise) price. It goes without saying that like any rational investor, he will prefer the higher price for his asset.
A binary option is out of money if the conditions specified for exercise to occur are not satisfied.
If the option is not out of the money, it is either at the money (ATM) or in the money (ITM).
The facts are the same as in Example 1 in article on in-the-money option. The following extract reproduces values of call and put options on AMD stock as at 19 July 2012.
|Exercise Price||Call Value||Put Value|
AMD closed at $4.03 as at 19 July 2013.
The call options with exercise price of $4.5, $5.0 and $5.5 are all out of the money because no rational option holder will prefer to purchase AMD stock at these prices under the option contract if he can purchase them at $4.03 in open market. The option contracts are in the money at all other exercise prices given.
The payoff pattern of a put option is just opposite to that of a call option. The put options with exercise price of $2.5, $3.0, $3.5 and $4.0 are all out of the money. It is because the option holder would rather sell the stock at $4.03 in open market than selling them under the option contract at much lower prices.
Written by Obaidullah Jan, ACA, CFA