An OTM option is comprised solely of extrinsic value, so any premium attached to it is due to time remaining to expiration. There is no intrinsic value for an OTM option.
For example, consider the following:
Out of The Money Call Option: when the current stock price is below the option’s strike price.
Out of The Money Put Option: when the current stock price is above the option’s strike price.
Extrinsic Value = Time Value
An option’s extrinsic value is the time value of an option. This is the remaining value of the contract after subtracting the intrinsic value. Extrinsic value will fully decay with time, declining to $0.00 by expiration. This is because at expiration, any option is only worth its intrinsic value, as there is no time remaining (extrinsic value) for price to make a move into or out of the money. The deeper an option goes ITM, the less extrinsic or time value it will have and the more intrinsic value it will have.
The more time there is until expiration, the greater the time value premium will be in the option. In addition, the farther away expiration is, a bigger move will be needed in the underlying stock to preserve the option’s value as time passes.
An option’s time value might erode in a predictable fashion as expiration approaches, but the time value will vary from one option to the next. This is based on several factors, such as the amount of time remaining until expiration. An option with very little time to expiry will have very little value, whereas an option with many months until expiration will have considerable time value. The narrower the distance between current prices and the strike price, the greater the amount of time value that option will have.
Other factors which will affect the amount of time an option carries include: the stock’s volatility and trade history, market expectations, scheduled news events (earnings announcements, corporate conference calls, etc.), industry-related developments, rumors and more. Anytime the perceived potential for the underlying stock to make a big move is increased, the time value of that option will increase as well. A sluggish stock with limited expectations by market participants will carry relatively little time value in its options.
An option is considered deep out of the money when the strike price is a great distance from current prices and the option has no intrinsic value. For example, deep OTM calls are strike prices which are well above current prices, and deep OTM puts are strikes which are well below current prices.
The deeper an option goes OTM, the less time value it will have and the more intrinsic value it will have. Also, deep OTM options carry a delta of nearly 0 because they are less sensitive to price movements in the underlying stock due to the extreme move needed to bring them into the money.
The TOS platform leaves OTM strikes in black while shading in-the-money strikes:
Return to the main options glossary page to learn more terms.