What is an Out of The Money Option?

by Manshu on January 13, 2009

in Articles

The world of finance is littered with jargon, and can get quite intimidating – even for pros. Most of this jargon stands for very simple concepts.

What makes it so obscure – is that you need to understand at least three or four different terms to make sense out of any one of them.

For this post – I will take a type of Option – Out of the Money Option – to explain what I mean.

To understand what – Out of the Money Option – means you need to understand at least the following terms:

  1. Strike Price
  2. Market Price
  3. Call Option
  4. Options and Derivatives

Out of the Money Option

An Out of the Money Option (OTM) is a Call Option whose strike price is greater than the market price, or, a Put Option, whose strike price is less than the market price.

So, the next obvious question is – What is a strike price?

Strike Price

Options are contracts that give the holder of the contract – the option to buy or sell a security. The price at which the holder can buy or sell a security is known as: Strike Price.

For example – If gas at the pump is 4 dollars today (Jan 2009), and I sign a contract with a gas station to let me fill gas at 4 dollars in Jan 2011- 4 dollars is the strike price.

Market Price

Market Price is simply the price of the underlying asset on the date the contract is traded. In our example – the market price is 4 dollars.

Call Option

A Call Option is a derivatives contract that allows the holder of the contract to buy the underlying asset. Our gas example is an example of a Call Option.

So, that means if gas is at 4 dollars today, and I hold a Call Option to buy gas at 5 dollars (strike price) in the future – I hold an – Out of the Money Call Option.

The strike price of the call option is greater than the market price.

Options and Derivatives

Options are simply contracts that give the writer of the contract – an option to either buy or sell a security at a future date. An option to buy a security is a Call Option. An option to sell a security is Put Option.

Options are one form of Derivatives.

Derivatives are a type of contract whose value is based on the value of some other asset. In short the value of the derivative will rise and fall with the value of the underlying asset.

For example – you can get into a contract with your teenage son on the length of his hair and his allowance. If the length of his hair increases – you reduce his allowance and vice-versa.

The allowance will then be a derivative – whose value will be based on the length of teenage son’s hair. Your son’s hair becomes the underlying asset.

The kind of Options that you can write is only limited by your imagination. You can look at the this Yahoo Finance link to see the kind of common Option contracts that are traded.

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