What is OTM Call Options?

Last Updated on November 7, 2023 by BFSLTeam BFSLTeam

Introduction

Options contracts come with specific terminology that is crucial for a comprehensive grasp of the concept.

• Options provide the opportunity to purchase a designated stock at a predetermined price within a specified timeframe, known as the expiration date. Importantly, holding an option does not impose an obligation to buy the stock; the buyer can choose not to exercise this option. To offer this flexibility, a premium is associated with these contracts.
• A Call Option represents the right to buy the specified asset.
• A Put Option signifies the right to sell the specified asset.
• Moneyness characterises the intrinsic value of an option’s premium in the stock market, serving as a guide for option holders to assess their potential for profit.
• The intrinsic value of a stock is most aptly described as the difference between its current market price and the strike price.
• The strike price is the actual transaction price at which the stock or asset is ultimately sold.

What is OTM in Options?

OTM, or Out of the Money, options refer to a specific category of options with no intrinsic value, relying solely on extrinsic value. In simpler terms, for investors to generate a profit with OTM options, the underlying stock must experience a significant price movement. What often makes OTM options attractive is their affordability, as they are among the least expensive options to acquire. Similar to other options like In The Money (ITM) and At The Money (ATM), OTM options grant investors the flexibility to choose between call and put options.

Also Read:  Rollover in the Stock Market

Understanding OTM Call Options

An OTM Call Option indicates that the current market price of the stock is lower than the strike price. Conversely, when the current trading value surpasses the strike price, the option is classified as OTM. As the name implies, using OTM calls places you “out of the money,” because acquiring the stock at the market price would yield more benefits than the cost incurred by exercising the strike price of the OTM call option. Investors can realise a profit through the put OTM option by selling the asset when its value experiences a significant increase before the contract’s expiration date. Otherwise, no profit can be made, as trading the stock at the market value would offer a superior return compared to the strike price.

Why Choose OTM Options?

The initial definition should not lead you to believe that OTM options offer no profit potential. If that were the case, there would be no reason for this classification. The interplay of moneyness and premium introduces crucial factors that affect the overall cost and value of a stock. An initially purchased OTM option may gradually transition towards becoming an ITM (In the Money) option, which carries a positive intrinsic value and higher profit potential. Therefore, if an option begins as Out of The Money, it might not remain so by the time the contract reaches its expiration date.

However, if an option remains OTM in stock market even at the expiration date, it becomes impractical to exercise. This is because exercising an OTM call option at expiration would result in purchasing the underlying stock at a higher price compared to buying the same stock at the prevailing market trading price.

Benefits of Utilising Out-of-the-Money (OTM) Options?

Out-of-the-money call options offer distinct advantages that have contributed to their widespread appeal. Let’s delve into the compelling reasons for traders to explore OTM options:

1. Potential for Larger Percentage Gains

Unlike their in-the-money and at-the-money counterparts, OTM options can yield greater percentage gains for similar price movements in the underlying asset.

2. Cost Efficiency

Due to their lack of intrinsic value, OTM options typically come at a lower absolute cost when compared to in-the-money or at-the-money options.

3. Reduced Price Point

OTM options are priced lower than options with a closer strike price to the current market price.

4. Calculated Risk

OTM options provide traders with a risk profile that can be more precisely calculated when compared to alternative strategies.

Also Read:  Implied Volatility In Options

In Conclusion

When it comes to utilising OTM calls, it’s crucial to recognize that this strategy demands a considerable amount of expertise to accurately predict whether a stock or asset will experience a significant rise by the options contract’s expiration date. This approach to trading is notably aggressive, offering the potential for substantial gains, but it is also associated with high levels of risk. Therefore, it’s best suited for traders with years of experience.

Experienced traders choose OTM options because they offer the highest percentage gains for the same movement in the underlying stock, surpassing At The Money and In The Money Options. However, OTM call options come with a primary cost in the form of the premium, and if you opt not to exercise your option, the entire contract essentially becomes worthless. Additionally, if you do decide to execute an OTM call or put option, it’s essential to account for often-overlooked factors like trading commissions and brokerage fees when calculating your actual potential profits. The total expense, inclusive of these costs, should be considered in order to determine the actual profit.

Just as there’s potential for significant gain if stock prices surpass the strike price during a sale, there’s also a substantial risk of loss if the opposite occurs. Using Out of The Money options necessitates careful decision-making, continuous monitoring of stock price trends, and a consideration of external global factors that could impact underlying stock prices.