Investing Assets & Markets Options The Right to Exercise an Out-of-the-Money (OTM) Option Understand an Out-of-the-Money Option and How to Hedge It By Mark Wolfinger Mark Wolfinger Twitter Mark Wolfinger was an options market maker at the Chicago Board Options Exchange (CBOE) for over two decades. He’s authored several books, including "The Rookie's Guide to Options," now in its second edition. Wolfinger has a bachelor's degree from Brooklyn College and a Ph.D. in chemistry from Northwestern University. learn about our editorial policies Updated on October 21, 2021 Reviewed by Erika Rasure Reviewed by Erika Rasure Erika Rasure, is the Founder of Crypto Goddess, the first learning community curated for women to learn how to invest their money—and themselves—in crypto, blockchain, and the future of finance and digital assets. She is a financial therapist and is globally-recognized as a leading personal finance and cryptocurrency subject matter expert and educator. learn about our financial review board Fact checked by Julian Binder Fact checked by Julian Binder Julian Binder is a fact checker, researcher, and historian. They were the recipient of the North American Studies Book Prize (2016, 2017), and they have previous experience as an economics research assistant. They have also worked as a writer and editor for various companies, and have published cultural studies work in an academic journal. As a fact checker for The Balance, Julian is able to utilize their experience as an editor and economics research assistant. Their role as fact checker is to review articles for accuracy, update data as needed, and verify all facts by citing trusted sources. learn about our editorial policies In This Article View All In This Article When a Buyer Might Exercise Examples of OTM Exercise Carrying Risk Final Thoughts Frequently Asked Questions (FAQs) Photo: Mint Images / Getty Images Trading using options is a method that traders use to try to purchase investments at an optimum price. An option can be exercised, or not, depending on the owner of the option. Two of the options for consideration are the put (the right to sell at a certain price) and the call (the right to buy at a certain price) options. "Out of the money" (OTM) refers to a situation in which an investor has purchased a call or put option on an investment. When an option is purchased, a strike price at which to sell or buy the asset is placed, regardless of the closing price. When the strike price is higher than the market price, a call option is referred to as being "OTM" (i.e., the buyer would pay more than the asset's market value). Similarly, an OTM put would have a strike price below the current market price. Key Takeaways A put option gives you the right to sell a stock at a certain price, while a call option gives you the right to buy it at a certain price."Out of the money" (OTM) refers to a situation where the strike price is higher than the market price for a call, or lower than the market price for a put.Professional traders may exercise OTM options at the time of expiration in order to eliminate risk.“Carrying the risk over the weekend” refers to not exercising options when the market closes on Friday. When a Buyer Might Exercise "Exercise" is a term that refers to initiating action on an option. In other words, exercising the right that you purchased to have an option to buy or sell at the price you agreed on. OTM options almost always expire worthless. However, there are situations in which an OTM call owner chooses to exercise their option. When an option is OTM by one or two pennies, it is possible, however unlikely, that the option owner would want to exercise it. When the option is OTM, and expiration arrives, the investor accepts the 100% loss of their purchase price and allows the option to expire. Professional traders or market makers (people who purchase stocks that are being sold by an investor, then resell them—essentially creating a market) will have instances when they exercise OTM options (at expiration). The primary reason is to eliminate risk. Professional traders earn their money by trying to find an edge in each trade. They do not "play the market," and they do not accept large amounts of risk. Therefore, they prefer to hedge positions (i.e., purchase other investments at the same time that will minimize any losses) and minimize the chances of losing money. Examples of OTM Exercise Suppose a trader is short 2,000 shares of a given stock (XYZ) and owns 20 expiring XYZ 50 calls (sell at $50, to reduce risk) as a hedge. He wants to cover the short position prior to expiration (in a declining price situation) and enters a bid of $49.98 for all 2,000 shares. Consider what happens when the stock closes at $49.99, on a Friday. The option is out of the money by one penny (because the price to purchase was dropping), and this market maker (MM) did not get the stock price they wanted. However, because of the buyer's protection against a large loss (the 20 XYZ 50 calls) expired, the risk of holding a short stock position is not what the market maker prefers to do. Thus, the buyer exercises the calls. Instead of paying $49.98, the MM is forced to pay $49.99 (the strike price for the calls). That is acceptable for this trader and is better than carrying risk over the weekend. Carrying Risk "Carrying the risk over the weekend" means not exercising options when the market closes on Friday. Consider that news of the short close is issued on Friday after the market closes. Monday's opening price for the stock will most likely be lower than Friday's closing price, increasing the losses for the MM if they did not exercise their options on Friday. The price would be lower, because demand would drop over the weekend. Call and put owners (investors who purchased options to buy or sell at certain prices) who learn about the pending short close before the cutoff time for option exercise (about 4:30 p.m. ET) begin to take action. Owners of slightly OTM call options notify their brokers to not exercise those options. Owners of slightly ITM (in the money) put options will instruct their brokers to not exercise them. Note Neither of these moves is automatic. To exercise an OTM option or allow an ITM option to expire, you must notify your broker before their cutoff time. When Monday morning arrives, and the stock opens for trading, the wisdom (or folly) of Friday's exercise/do-not-exercise decisions results in a large loss for anyone with an option on that specific stock. Final Thoughts This worst-case scenario does not happen very often. It is meant to help you understand the exercise of OTM options, the effect it can have, and how to reduce the risks of call and put options. Frequently Asked Questions (FAQs) How do OTM puts make money? Puts that expire out-of-the-money will be worthless, but OTM puts can still create profitable trades if the price of the underlying stock falls. If it does, and the OTM put price increases, then you can sell that put for a profit before it expires—even though it isn't in the money. An option's delta is useful for this kind of trade, because it measures how sensitive an option is to changes in the underlying stock's value. How do you buy puts? You must typically request extra permissions from your brokerage to trade options. Once you've successfully applied to upgrade your brokerage account, you simply place a buy order as you would with any other stock. Keep in mind that options contracts don't trade with as much volume as the underlying stock, and that lack of liquidity can affect the prices you get on market orders. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Fidelity. "The Power of Delta."