Deep Out of the Money

What Is Deep Out of the Money?

An option is considered deep out of the money if its strike price is significantly above (for a call) or significantly below (for a put) the current price of the underlying asset. Typically, this means the strike price of the option must be more than a few strikes in the option chain away from the price of the underlying asset.

Understanding Deep Out of the Money

In order for a call option to have value at maturity or expiration, the price of the underlying asset must be above the option's strike price. For a put option, the price of the underlying must be below the option's strike price. If neither is true, then the option will expire worthless. Therefore, the deeper out of the money the option is, the more likely that it will expire worthless.

Out of the money options have no intrinsic value and trade on their time value. The deeper out of the money the option, the more exaggerated this becomes. Conversely, in the money options have both intrinsic value and time value.

For example, if the current price of the underlying stock is $60, a put option with a strike price of $45 would be considered deep out of the money. A put option with a strike of $40 would be even deeper out of the money.

Trading Strategy

While a deep of out the money option seems worthless, the derivative still holds some value. All options, both in and out of the money, contain time value. Time value measures the benefit of having an option with time remaining until maturity with at least some chance that the price of the underlying will move towards the desired strike.

Therefore, while a deep out of the money call or put has no intrinsic value, some investors are willing to pay a small amount for the remaining time value. However, this time value decreases as the option moves closer to its expiry date.

The obvious feature of deep out of the money options is their very low cost compared to comparable options with strike prices closer to the price of the underlying. The risk that the options will expire worthless is great but so is the potential size of the reward, should the option move in the money before expiration. If the latter becomes true, the percentage payoff can be huge. The small amount paid for the option could multiply many times over. One hundred percent gains are actually on the low side of possibilities.

It is tempting to buy deep out of the money options on many assets at one time because only a few need to be successful to create an overall portfolio gain. However, commissions compound the costs and some experts consider these types of options to be gambling with a high possible payoff but with very low odds of success.