Out of the Money Stock Option

An out of the money stock option (OTM) refers to an option that is passed its stock price. For a call the OTM would be all options with a strike price above the stock price. For a put the OTM would be all options with a strike price below the stock price.

For instance, say you buy a $45 call for $ .5 on stock XYZ. Stock XYZ however is only trading at $42. You have the right to buy this stock at $45 in the future. So this stock would have to go up above $45.5 for you to make money on it.

As you can probably realize this is an extremely risky way to trade. If you look at it, you have already set the odds against you when you made this trade. Ok XYZ is a great stock that is going to move up. But it has to go up above $45.5 for you just to break even with this stock.

That is $2.5 before you break even. And then if you want to actually make any profit on it, it has to go up even more. Buying an OTM is a very risky trade.

If you wanted to still cash in on the upward movement of the stock with options, but with lower risk try buying an ITM option. An example of an ITM option would be if we bought a $40 call for $6. Now we do not need a big move in the stock. If it goes up we are happy to take a profit.

The benefit of an OTM option as opposed to an ITM option is the large potential return. If stock XYZ went up to $50 our $40 ITM option would be worth at least $10. This would give us a 66% gain in the option price. Not bad.

But Our OTM option would be worth at least $5. This would give us a 900% gain. See the difference.

Some traders prefer out of the money stock options for that reason. They prefer higher risk higher reward trades. They normally expect a big move really fast. If you are expecting a big move fast why not use OTM options. These traders need to be extremely good at position sizing, because they are taking such high risks.

The decision to buy an OTM option is up the individual trader. Anyone why buys out of the money option should be prepared to lose their premium.