What it means
Every option has a strike price, which is the fixed price at which the holder can buy or sell. Out of the money simply means the market has not reached that level: for a call the market price is below the strike, and for a put the market price is above it.
The gap between the two is often quoted directly, as in "out of the money by $7". The significance is that intrinsic value, meaning the immediate profit from exercising, is zero.
Whatever the option costs is entirely time value, which is the market's price for the possibility that things change before expiry. That time value shrinks as expiry approaches, quickly in the final weeks.
Out of the money options are the cheapest way to buy protection against an unlikely but painful event, which is why treasurers and risk managers favour them. Paying a small premium for a contract that only pays out in a severe move is a deliberate choice to insure the tail rather than the whole distribution of outcomes.
Sellers approach the same contracts from the opposite side. Writing out of the money options generates steady premium income in calm markets, but the seller carries the loss when a large move finally arrives, so the strategy looks profitable for long stretches and then reverses sharply.
There is also a corporate finance use of the phrase. Convertible bonds are described as out of the money when the share price sits below the conversion price, which tells investors the bond is behaving like ordinary debt rather than like equity.
In practice
Real-world examples.
Example
A grain exporter buys out of the money currency puts to protect against a 10% fall in its home currency. Nine quarters out of ten the contracts expire worthless, and the premium is treated as an ordinary cost of doing business.
Example
A convertible bond has a conversion price of $65 while the shares trade at $41. Analysts describe the conversion feature as out of the money, so the bond trades on its yield rather than on equity upside.
Example
A hedge fund sells out of the money call options on a stock it already owns, at a strike 15% above the market. The premium adds income each month, and the fund accepts that a strong rally would cap its gains at the strike.
Think of it
“Out of the money means the option has no immediate value-it wouldn't be profitable to exercise.
Formula
Calculation
For a put: out of the money when market price > strike price, and intrinsic value = 0. Break-even at expiry = strike price - premium paid.
A pension fund holds 20,000 shares of an industrial group trading at $47 and buys protective puts with a $40 strike, so the contracts are out of the money by $47 - $40 = $7 per share. The premium is $0.80 per share, and with 100 shares per contract the fund needs 200 contracts to cover 20,000 shares.
The total premium is 20,000 x $0.80 = $16,000, and break-even at expiry is $40 - $0.80 = $39.20. If the shares finish at $44, the puts expire worthless and the fund has spent $16,000 on protection it did not need. If the shares crash to $30, each put is worth $40 - $30 = $10, so the payout is 20,000 x $10 = $200,000 against a share loss of 20,000 x ($47 - $30) = $340,000.Case study
Seen in the real world.
This is an illustrative, fictional scenario. Calderwood Freight, an invented haulage group, spent $220,000 a year on out of the money diesel call options struck well above prevailing prices. For four straight years the contracts expired worthless, and the finance director faced steady pressure from the board to stop wasting money on insurance that never paid.
In the fifth year of this fictional example, a supply shock pushed diesel up by roughly 60% in three months, and the options paid out $2,900,000, comfortably more than the $1,100,000 of premiums spent over five years. More importantly, Calderwood could hold its contracted haulage rates while two smaller rivals were forced to renegotiate with customers mid-contract.
The illustrative lesson the board drew was about framing: out of the money protection should be judged over a full cycle, in the same way nobody calls a fire policy wasted because the building did not burn down.
Watch out
Common mistakes.
- Believing an out of the money option costs nothing, when it carries a real premium that is lost if the market never moves far enough.
- Judging a hedging programme by whether last year's options paid out, rather than by whether the cover was priced sensibly.
- Mixing up out of the money puts and calls, since the same market move makes one cheaper and the other dearer.
Questions
People also ask.
How far out of the money should a hedge be?
Far enough that the premium is affordable but close enough that the payout starts before the loss becomes serious, which usually means somewhere between 5% and 20% away from the current price.
Does an out of the money option have any value on the balance sheet?
Yes, it is carried at fair value, which is small but positive until expiry.
Is out of the money the same as OTM?
Yes, OTM is simply the abbreviation used in trading screens and broker statements.
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