How “Out Of The Money” Options Can Amplify Profits And Reduce Risk
Newer traders often find that one of the roadblocks to learning options is the associated terminology. This can be frustrating, so we’ve spent some time over the past few weeks going over some basic terms that you need to know.
Today, let’s cover “out of the money” options, including what they are and how traders can use them to profit.
(We recently covered in the money options here).
What Are Out Of The Money Options?
Options give the holder the right to buy or sell an underlying security. These contracts are for a predetermined strike price for a limited amount of time.
An option is considered “out of the money” if it has no intrinsic value. This occurs when:
- Call Options: The underlying asset’s market price is lower than the option’s strike price.
- Put Options: The underlying asset’s market price is higher than the option’s strike price.
In other words, if the underlying security trades at a price that makes the exercise of the option unprofitable, then it is trading “out of the money.”
Out Of The Money Vs. In The Money
The following table shows the “moneyness” of a fictional “XYZ” stock trading at different prices in relation to its call and put options at the $75 strike price.
Call options are out of the money when the market price of the stock is below the strike price of the option. For example, a call on XYZ with a strike price of $75 is out of the money with the stock trading at $70 a share.
To exercise the option at the $75 strike price, the trader would have to buy XYZ for $5 more than the current market price. In other words, exercising the options would be more expensive than simply buying XYZ at the market price — resulting in a loss.
Put options are out of the money when the market price is more than the strike price. So a put on XYZ with a $75 strike price is out of the money with XYZ trading at $80 a share.
Why Out Of The Money Options Matter To Traders
Traders can target big gains with a small amount of risk using out-of-the-money options. This is because they often trade at a low price. The further the underlying security is from the strike price, the less the option should trade.
For example, let’s say a trader expects a very large upward price move in gold. They could buy 100 shares of SPDR Gold Shares (NYSE: GLD), or they could buy an out-of-the-money call option for much less. If GLD is trading at $180 per share, the investor will pay $18,000 for 100 shares. But just as an example, let’s say an option trader would only pay $2.40 per share, or $240 per contract (which controls 100 shares), for a $200 strike call with 60 days till expiration.
If GLD rallies 20% and reaches $216, the option will now be worth $16 ($216 market price minus $200 strike price). That’s good for a 566% gain for the options trader (ignoring transaction costs).
In total dollar terms, the investor who bought 100 shares would make $3,600. But keep in mind, this would require an $18,000 investment.
On the flip side, traders can use low-cost, out-of-the-money puts to speculate on big downside moves.
Additionally, some traders will buy puts that are out of the money to hedge their investments. A put with a strike price 20% below the current market price, for example, will deliver profits only if the stock price falls by more than 20% before the option expires. Traders can spend a small amount on these options to protect themselves against crashes. Unfortunately, this strategy leads to a large number of small losses and only a very occasional winning trade. This could make it unprofitable for most traders in the long run.
Out-of-the-money options allow traders to amplify their profits with a relatively small investment. This strategy also limits risk since the trader who buys an option cannot lose any more than the initial cost.
Buying out-of-the-money put options can offer some degree of protection against market crashes. Constantly holding a small position in these options is likely to be unprofitable over the long run. But at times when traders feel risk is high, they can use this strategy to protect their portfolio.
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