The degree to which an option has intrinsic value or not is known as money.
You’ve heard before people use terms like “at-the-money” or “in-the-money” and it’s about option money.
Today we’re focusing on out-of-the-money (OTM) options.
Remember, money only earns its intrinsic value.
Note the following formulas for calculating the option premium.
Long or short option positions are not mentioned. This means that the option has no impact on the amount of money regardless of whether you have a long or short option.
Let’s take a look at the call and set options to make sure we understand the option values.
- Call option: intrinsic value (share price – exercise price) + external value = option premium
- Put option: intrinsic value (exercise price – share price) + external value = option premium
In short, if intrinsic value is positive these options are ITM. Conversely, options are out of the money when their intrinsic values are negative.
Here is a simple reference table to help you keep it straight in your head.
Another thing we need to discuss regarding option money is the term that is applied deeply to our ITM and OTM options.
There is no clear definition of when an option moves into the deep category.
Sometimes you will see an option called a Deep ITM or Deep OTM when referring to an option whose strike is $ 5 or $ 10 from the current market price.
I prefer a more logical approach that applies the term deeply to options with a delta close to 1 for calls and -1 for puts.
So ITM options have high intrinsic value and are sometimes used as a substitute for stocks, as in the The poor man’s secret phone call Strategy.
Since ITM options have high intrinsic value, this means that OTM options need only have very little intrinsic value.
When OTM options have so little intrinsic value, they must have a great deal of external or time value.
Sounds a lot like a lottery ticket or a game of chance, doesn’t it?
OTM options tend to be very cheap and when they pay off they bring a very good return on your investment.
The other side of the coin is that the probability of winning is rather low, as there is no free lunch.
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We said earlier that long or short positions do not affect money and it is true.
However, it is important to understand that OTM options are generally good for short positions, while OTM options are usually not good for long positions.
This applies equally to calls and puts.
For example, if the market price of a stock is $ 50 and I hold an OTM strike long call option of $ 60, the stock price needs to be increased by $ 10 for my option to be profitable.
However, if I hold the short side of the same call option, my call option will be profitable unless the stock price goes up $ 10.
If I hold an OTM strike long put option of $ 40 in the put option version, the stock price has to fall by $ 10 for my option to be profitable.
However, if I hold the short side of the same put option, my put option will be profitable unless the stock price falls $ 10.
Another consideration is that since OTM options are also OTM, your risk is there Assignment is minimal.
Let me begin this section with a cautionary note.
I’ll be sharing how you might use OTM options, but I’m not necessarily in favor of your use of these options.
Using bare (undefined risk) option positions can expose you and your account to significant risk.
OTM options could very well be used for speculating.
Let’s say you’ve done your analysis and you think the stock you are analyzing is ready to take a bigger move or make a correction.
I did that before myself.
In fact, I just bought 2 $ 80 OTM strike calls from MRK just last week.
The market price closed around USD 75 on Friday.
The stock is near 52-week lows, both the CCI and RSI are near oversold, and the IV percentage is 10%.
I think this stock is about to rebound and that position cost me $ 188 ($ 0.94 x 2).
I don’t do much of this type of trade, but I like doing a few “for fun” trades every now and then.
OTM options can also be used to hedge a position or your portfolio.
I use OTM options to hedge my portfolio using VIX options.
The way it works is I buy 10 Delta VIX calling options with 120 DTE every 30 days. This creates an option ladder.
What happened is I ended up with VIX calling options that expire every 30 days for the next 4 months from today.
I limit my association with this strategy to 1% of my account.
So I use 0.25% of my account every month to buy VIX calling options.
How does this create a hedge for my portfolio? Let me ask you a question.
What will most likely happen to the volatility when the market hard armors and the SPY drops several hundred points?
It will probably skyrocket, right?
These VIX options will hopefully go up in price, which will offset the losses in my other positions that followed the market into the pit.
These two examples used long OTM options, but what about short OTM options?
They can also be used, but they can expose you to significant price movement risk.
If you think a stock may be moving and some binary events like profits and dividends are imminent, but you still want to take advantage of them, OTM short options might work for you.
In addition to the risk, the premium you get from them is usually very small.
I wouldn’t go into this situation as there are far better trading instruments out there.
Disclaimer: The above information applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.