The term out of the money refers to a strike price on a vanilla equity option that is above the current market price for the underlying stock in the case of a call option and below in the case of a put option.
Out of the money options have no intrinsic value, as they are currently worthless to exercise, while they do retain extrinsic value as a result of their time value, where the market price still has time to change in favor of making the option profitable to exercise.
The opposite of an out of the money option is an in the money option.
A standard vanilla equity option gives the holder the right, but not the obligation, to buy (call option) or sell (put option) a set amount of shares at a given price (the strike price).
The holder of the options turns a profit on the exercising (the execution of the contracted transaction) of the options when the strike price is below the market price in the case of a call and above in the case of a put.
Out of the Money Example
Take an underlying stock with a current market price of $40 per share. Any call options with a strike price of more than $40 or put options with a strike price of the less than $40 are out of the money.
For example, if the holder of a call option with a $45 strike price were to exercise the option, the option writer would be obligated to sell the holder shares of the underlying security at $45 per share.
However, the holder of the options could just buy the same shares from the market at $40 per share, leading to a loss of $5 per share by exercising the options.
You can see in the image above with the Calls on the left and Puts on the right that the out of the money strike prices are both cheaper and tend to have more volume. Out of the money Calls are on the lower left side while the out of the money Puts are on the upper right side.
Out of the Money and Trading
Many option chains displaying lists of options available for trading can be sorted according to their being out of the money or in the money. Each type of option tends to attract a different sort of trader.
Traders use out of the money options when they are expecting a large change in the market price of a share or they wish to hedge against a significant price change on a current position.
Since out of the money options have no intrinsic value, they are comparatively inexpensive, and provide traders with the opportunity for significant profits or act as an inexpensive form of insurance on an existing position.
Many day traders choose to trade almost exclusively in out of the money options due to their low premium cost and potential for significant rates of return.
Due to their low initial value, out of the money options can increase by many times their initial value in a matter of hours or even minutes according to changes in the price of the underlying stock.
Furthermore, the small initial premium means that day traders can use out of the money options to hedge their riskier positions, and the small loss of premium will be negligible when compared to the gains from a successful trade.