What are OTM Call Options

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  • 28 Sep 2023

In the world of stock market trading, a wide array of investment strategies and financial instruments exist to help investors maximize their returns and manage risk. One such instrument is the Out-of-the-Money (OTM) call option. So, what is it? Let's find out.

Before we dive into the specifics of OTM call options, let's clarify what OTM means. OTM stands for Out-of-the-Money, and it is a term used to describe an option contract whose strike price is not favorable for exercising at the present market cost of the underlying asset.

An OTM call option is one in which the asset's market cost is below the strike price. This means that if you were to exercise the option at that moment, it would result in a loss. OTM options are an important aspect of derivatives trading and play a vital role in hedging and speculative strategies.

OTM call options come into play when the underlying asset's market price is below the strike price. In this scenario, it may not make sense for an investor to exercise the call option because doing so would mean paying more for the asset than its current market value.

Now that you know the OTM meaning, let's illustrate the concept of an OTM call option with a hypothetical scenario involving XYZ Ltd stock. Suppose XYZ Ltd. is currently trading at INR 1000 per share, and you purchase an OTM call option at a strike price of INR 1200 that expires in one month. If, at the expiration date, the price of XYZ Ltd. remains below INR 1200, your OTM call option will expire worthless. However, if the price of XYZ Ltd. rises above INR 1200, your call option may become profitable.

OTM call options can still be valuable in several ways:

  • Speculative Potential: Traders often use OTM call options for speculative purposes. These options are relatively inexpensive compared to in-the-money (ITM) or at-the-money (ATM) options. If the trader anticipates a significant price movement in the underlying asset before the option's expiration, an OTM call option can offer substantial returns. If the asset's price surges and crosses the strike price, the option can become profitable, potentially yielding a higher percentage return on investment compared to buying the underlying asset.

  • Limited Risk: One of the primary advantages of OTM call options is that the risk is limited to the premium you pay for the option. Since the option is already out of the money, there is no intrinsic value, and the entire premium consists of time value. This means that even if the trader's forecast is incorrect, and the option expires worthless, the only loss they suffer is the premium paid for the option, which can be a fraction of the cost of the underlying asset.

  • Leverage: OTM call options provide traders with leverage. This means that a small price movement of the underlying asset can cause a significant percentage gain in the option's value. This leverage can amplify returns compared to investing directly in the asset. However, it's essential to note that leverage can work both ways, increasing both potential gains and potential losses, so it should be used judiciously.

  • Portfolio Diversification: Traders can use OTM call options to diversify their portfolio and manage risk. By holding various options with various strike prices and expiration dates, traders can create a diversified strategy that hedges against adverse price movements in the underlying assets. This diversification can help balance a portfolio and reduce overall risk exposure.

  • Strategies and Hedging: Traders often use OTM call options as part of more complex options trading strategies. These strategies may involve combinations of different options contracts to achieve specific risk-reward profiles. Additionally, OTM call options can be used as a component of hedging strategies to protect against potential losses in a portfolio or offset losses in other positions.

  • Timing Opportunities: OTM call options allow traders to take advantage of timing opportunities. Suppose a trader believes that a significant price move in the underlying asset is imminent. In that case, an OTM call option can offer a cost-effective way to participate in that potential price rise without committing a large amount of capital.

Using OTM call options can be a valuable strategy for investors. However, it's crucial to approach them with caution and a clear understanding of their advantages and risks. Here are some key things to keep in mind while using OTM call options:

  • Understand the Basics: Before diving into OTM call options, make sure you have a solid understanding of how options work, including concepts like strike prices, expiration dates, premiums, and the difference between call and put options.

  • Risk Tolerance: Assess your risk tolerance carefully. OTM call options can be cheaper than in-the-money (ITM) or at-the-money (ATM) options, but they are also riskier. You may lose the entire premium if it expires worthless.

  • Market Research: Conduct thorough research on the underlying asset. Understand the company, its financials, and the factors that could influence its price. OTM call options are speculative, so a strong fundamental or technical analysis can be beneficial.

  • Volatility: Consider the volatility of the underlying asset. Highly volatile stocks may be more suitable for OTM call options because they have a better chance of making significant price moves.

  • Time Horizon: Determine your investment time horizon. OTM call options have expiration dates, and the longer the time until expiration, the more time there is for the market to move in your favor. Be aware of the time decay factor.

  • Price Target: Have a clear price target in mind. OTM call options become profitable when the underlying asset's price moves significantly above the strike price. Set realistic and achievable price targets based on your analysis.

  • Position Sizing: Carefully consider the size of your position. Don't commit more capital than you can afford to lose. Diversify your investments to manage risk effectively.

  • Exit Strategy: Plan your exit strategy in advance. Decide when you will sell the OTM call option if the market moves in your favor and when you will cut your losses if it doesn't. Stick to your plan to avoid emotional decision-making.

Wrapping it Up

OTM call options are a vital component of options trading. It offers traders various strategies for speculation, risk management, and portfolio protection. Understanding the concept of OTM, its meaning, and its potential uses can empower Indian investors to make informed decisions in the dynamic world of financial markets.

FAQs on OTM Call Options

Exercising the OTM call option at expiration results in purchasing the underlying stock at a price higher than if you had acquired the same stock at its prevailing market trading price.

If you buy call options with a strike price of Rs. 1000, the option will be considered in the money when the current stock price is below Rs. 1000.

When trading deep In-the-Money (ITM) options, you can take advantage of their substantial intrinsic value, closely mirroring the price fluctuations of the underlying asset. Conversely, deep Out-of-the-Money (OTM) options can serve as instruments for speculative maneuvers, harnessing substantial price swings and the potential for substantial, outsized returns.

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