What Does Out-of-the-Money Mean?
An option is out-of-the-money (OTM) when exercising it immediately would result in a loss or no economic benefit. A call option is OTM when the stock price is below the strike price, meaning you would be buying the stock above market price. A put option is OTM when the stock price is above the strike price, meaning you would be selling below market price. OTM options have zero intrinsic value; their entire premium consists of time value.
Despite having no immediate exercise value, OTM options are the most actively traded options in the market. They offer high leverage, defined risk (you can only lose the premium paid), and require less capital than ITM or ATM options. However, OTM options also have a lower probability of profit and lose 100% of their value if the stock does not move far enough before expiration.
OTM Calculation Formulas
- 1OTM amount = $100 - $95 = $5.00 (5.26% OTM)
- 2Intrinsic value = $0 (all time value)
- 3Stock move needed to reach strike = +5.26% ($5.00)
- 4Breakeven = $100 + $2.50 = $102.50 (stock must rise 7.89%)
- 5Probability of reaching $100 ≈ 30% (based on Delta ~0.30)
- 6Probability of profit (reaching $102.50) ≈ 22%
- 7Maximum loss = $2.50 × 100 = $250 per contract
- 8If stock reaches $110: profit = ($110 - $100 - $2.50) × 100 = $750 per contract
OTM Options: Risk vs. Reward
| Strike | OTM % | Premium | Breakeven | Prob. Profit | Return if +10% |
|---|---|---|---|---|---|
| $102 | 2% | $2.80 | $104.80 | 32% | $186% |
| $105 | 5% | $1.50 | $106.50 | 20% | $233% |
| $108 | 8% | $0.70 | $108.70 | 11% | $186% |
| $110 | 10% | $0.35 | $110.35 | 6% | Breakeven risk |
| $115 | 15% | $0.08 | $115.08 | 1.5% | Worthless |
When to Trade OTM Options
- Directional speculation with limited capital: OTM options let you participate in large moves with a small investment
- Portfolio insurance: OTM puts protect against large drops without the expense of ITM puts
- Income strategies: Selling OTM options (covered calls, iron condors) has a high probability of the option expiring worthless
- Event-driven trades: Before earnings or catalysts where a large move is expected in a specific direction
- Spread wings: OTM options serve as the short legs in spreads and the wings in iron condors and butterflies
Smart OTM Trading Practices
Buying cheap weekly OTM options is one of the most common mistakes among new options traders. A $0.25 option that doubles in price still only pays $0.25 per share, while the probability of even reaching that point is often less than 10%. Over time, these small bets compound into significant losses.
For option sellers, OTM options are the bread and butter of income strategies. An OTM covered call with Delta 0.25 has roughly a 75% chance of expiring worthless, allowing you to keep the entire premium. The key is consistency: selling premium month after month compounds into meaningful annual returns.