Options contracts give the holder the right to buy or sell an underlying security at a predetermined strike price for a limited amount of time. If the underlying security is trading at a price that makes the exercise of the option unprofitable based on the strike price, then the options contract is trading "out of the money."
Call options will be out of the money when the market price of the underlying security is below the strike price. For example, a call on Apple (Nasdaq: AAPL) with a strike price of $400 is out of the money with Apple trading at $200 a share.This is the case because to exercise the option at a strike price of $400, the trader would have to buy AAPL at a price that is $200 more per share than the current market price. Exercising the options in this example would be more expensive than simply buying AAPL at the current market price. Since there is no value with exercising the option, it is "out of the money" and a trader would suffer a loss if they chose to exercise the option.
Put options are out of the money when the market price of the underlying security is more than the strike price. So a put on Apple with a $100 strike price is out of the money with Apple trading at $200 a share.
How Traders Use It
Traders can target big gains with a small amount of risk using out-of-the-money options 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.
For example, if 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 $130 per share, the investor will pay $13,000 for 100 shares. The option trader may only pay $0.20 per share, or $20 per contract (which controls 100 shares), for a $150 strike call with 60 days till expiration.
If GLD rallies 20% and reaches $156, the option will now be worth $6 ($156 market price minus $150 strike price), for a 2,900% gain for the options trader (ignoring transaction costs).
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 market crashes.
Unfortunately, this strategy leads to a large number of small losses and only a very occasional winning trade, making it unprofitable for most traders in the long run.
Why It Matters To Traders
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 of the option.
Buying out-of-the-money put options can offer some degree of protection against market crashes. While constantly holding a small position in these options is likely to be unprofitable over time, at times when traders feel risk is high, they can use this strategy to protect their portfolio.
(This article originally appeared on ProfitableTrading.com.)