Out-of-the-Money (OTM)

Out-of-the-money, usually shortened to OTM, is a description of an option's strike price relative to where the underlying stock is currently trading. An option is a contract that gives its buyer the right to buy or sell a stock at a fixed price, called the strike price, by some expiration date. Whether that right is currently worth exercising is what "in the money" or "out of the money" describes.

For a call option, which gives the right to buy the stock at the strike price, the option is out-of-the-money when the strike is above the current market price. Nobody would exercise the right to buy at $110 when the stock is trading at $100, so that call has no built-in value right now. For a put option, which gives the right to sell at the strike, it is out-of-the-money when the strike is below the current market price — the right to sell at $90 is worthless to exercise if the stock is trading at $100.

Because an OTM option has no built-in, exercise-now value, its entire price is made up of what's called extrinsic value: the market's estimate of the chance the stock moves far enough, in time, for the option to become worth exercising before expiration. That value comes from time remaining and expected volatility, and it shrinks as expiration approaches, a process traders call time decay. This is why OTM options are cheaper than in-the-money ones — you're paying only for a possibility, not for something already true.

The nuance that trips people up is that "out of the money" is not the same as "worthless" or "bad." OTM options are cheap precisely because they need the stock to move; that makes them higher-risk but higher-percentage-return bets if the move happens, and it's also why most OTM options expire worthless. It's also easy to mix up calls and puts here — the direction that counts as OTM flips depending on which type of option you hold.