Out of the Money Options Explained (Simple Guide)
If you bought a stock option, it could be “out of the money.”
But what, exactly, is “out of the money”?
It means that, for the moment, the underlying stock has yet to move beyond the option’s strike price.
There’s a lot going on in that last sentence. I’ll break it all down in this guide.
The Strike Price
Before you can determine if an option is in the money, you have to look at its strike price.
All options, whether they’re call options or put options, have a strike price. It’s an important number because you only exercise your right to buy or sell the shares of stock once they hit that price on the open market.
Let’s say you buy a call option for Microsoft. It expires next month and has a strike price of $103.
That means you can exercise your right to buy shares of Microsoft if the stock moves higher than $103 when the contract expires.
If the stock stays below $103, you don’t need to exercise your right to buy the shares because you can buy Microsoft on the open market at a lower cost.
Out of the Money and Strike Price
Once you know the strike price, you can easily determine if the option is out of the money.
A call option is out of the money when the market value of the underlying stock is lower than the strike price.
A put option is out of the money when the market value of the underlying stock is higher than the strike price.
In the example above, the Microsoft call option that you bought stays out of the money as long as shares of Microsoft trade for less than $103 per share.
On the other hand, if you had purchased a $103 put option, then it would stay out of the money when shares trade for more than $103 per share.
An option contract has no intrinsic value when it’s out of the money.
That’s because it’s speculative. The option hasn’t yet reached the target strike price and, for the moment, isn’t eligible for exercise.
Keep in mind: that doesn’t mean it will never have intrinsic value. Stock prices are known to fluctuate.
Out of the Money Doesn’t Mean Unprofitable
You might think at this point that an out of the money option contract means that the owner of the contract won’t earn a positive return when it expires. That’s not necessarily the case.
Let’s say that you paid $6 for that Microsoft $103 call option when the stock was trading at $98 per share. The next day, Microsoft shares jump up to $102 per share.
The option is out of the money because shares of Microsoft are trading for less than the strike price. However, the trade is profitable.
The contract you purchased will probably be worth around $11. Since you paid $6 for that option, you earned an almost 100% return in just one day!
Also, if you were short that call option, you’d want it to stay out of the money. It’s better for you if it drops in value.
Out of the Money Doesn’t Mean It’s Time to Sell
You might think that you should sell a stock option if it stays out of the money. That’s not true, either.
Why? Because the underlying stock might still move in your favor. If that happens, you could turn a profit.
Be on the lookout for time decay, though. Options have a tendency to decrease in value over time even if the underlying stock price doesn’t move.
Also, just because a long call option is out of the money, it isn’t necessarily unprofitable (see above). You could earn a healthy return by hanging on to options that haven’t yet hit the strike price.
And, once again, if you’re short the option, you might decide to “let your winner run” and wait for the underlying stock to drop even more so you can earn a larger profit.
Out of the Money and Delta
When traders evaluate individual options, they’ll often use “the Greeks.” Those are statistical measures that give insight into the viability of specific trades.
One of the Greeks is delta. It measures an option’s price sensitivity relative to its underlying security.
Delta answers the question: “How much will this option change in price for every dollar in price movement of the underlying stock?”
For call options, delta is expressed as a number between 0.0 and 1.0. For put options, it’s expressed as a number between 0.0 and -1.0.
Here’s how it works: if the Microsoft call option mentioned above has a delta of .75, then that means the option will increase 75 cents (or .75 of a dollar) for every dollar increase in Microsoft stock.
Options that are out of the money have delta values that approach 0. Options contracts that are well out of the money (i.e., farther away the strike price), have deltas closer to 0.
In other words, you can expect a deep out-of-the-money option price to change very little with its underlying stock.
For example, let’s say that Microsoft is trading at $80 per share when you purchased that $103 call option. In that case, if shares of Microsoft go up by $1, don’t expect the option price to increase by $1 as well. In fact, it will likely only increase a few pennies (if at all).
Out of the Money and Covered Calls
If you own shares of a stock, you can always sell a covered call option. That’s when you give somebody else the right to purchase your shares at a specific price at some point in the future.
That “specific price,” of course, is the strike price. The point in the future is the contract expiration date.
If you’d like to hang on to those shares of stock and you’re just selling the covered call option to generate some quick cash, then you want the option to stay out of the money. That way, you’ll keep the cash you earned from the sale of the call plus your shares of stock.
On the other hand, if you don’t mind selling the shares at a price above the current market value, then you want the shares you own to reach the underlying strike price. If that happens, the person who bought the option from you will exercise his or her right to buy the shares at that price.
Plus, you’ll keep the money you earned from selling the option.