What are OTM Call Options?

There are times in the stock market when we expect a stock’s price to rise but don’t want to risk a large amount of capital. In such cases, OTM (Out of the Money) call options can be a cost-effective and limited risk strategy. These are call options with a strike price higher than the current market price, meaning they involve relatively small upfront costs but offer the potential for significant returns. 

In this blog, we will explain in simple language what OTM calls are, how they work and when it is appropriate to use them.

What is an Option?

An option is a type of derivative contract that gives you the right but not the obligation to buy or sell a stock or index at a fixed price called the strike price on or before a specific date. Options are widely used for trading, hedging, and speculation.

Key Terms You Must Know

1. Call Option : It gives you the right to buy a stock at a fixed price. It is bought when you think the price of the stock will rise.

2. Put Option : It gives you the right to sell the stock at a fixed price. It is used when you expect the price to fall.

3. Strike Price : This is the price at which you can buy or sell the stock.

4. Premium : The amount you pay to buy the option is called premium. This is the upfront cost.

5. Expiry Date : This is the last date till which the option is valid. After this date the option expires.

What are OTM Options?

OTM (Out of the Money) options are those that have no intrinsic value based on the current market price. In other words, if the option were to expire today, it would be worth nothing because the strike price is not favorable for immediate exercise.

OTM options are cheaper in premium, as their probability of turning profitable is comparatively less. But this is what makes them attractive for low-cost and high-risk speculative strategies.

OTM options are mainly of two types:

• OTM Call Option
• OTM Put Option

What are OTM Call Options?

A call option is a derivative contract that gives a person the right to buy a stock or index at a specified strike price in the future. When we talk about OTM call options, it means that the strike price of the option is above the current market price of the underlying asset.

For example, if Nifty is currently trading at 25,000 and you buy a call option at 25,300, it is an OTM call option. OTM options have a lower premium because they are less likely to be profitable at expiry. But this low cost makes them attractive for speculative trades.

How Do OTM Call Options Work?

• Low premium, high potential returns : OTM call options are generally cheaper because they currently have no intrinsic value. They have value at expiry only when the price of the underlying asset rises significantly above the strike price. This lower cost of entry makes them attractive, but the probability of profit is smaller, which also makes them a higher-risk choice.
• The premium is your entire risk : When you buy an OTM call, you pay only the premium – and this is your maximum loss limit. If the stock price does not reach the strike price by expiry, you lose only the premium, not more than that.
• Time Decay causes a decline in value : The effect of time decay (theta) on the value of OTM options is faster. As the expiry approaches, if the price does not move, the value of these options starts falling rapidly.
• Breakeven Point is Strike Price + Premium : You make profit from OTM calls when the stock price goes above (strike price + premium). For example: If you bought a call option with a strike price of ₹220 and paid a premium of ₹10, then your breakeven will be ₹230 at expiry.

Read Also: Call and Put Options: Meaning, Types, Difference & Examples

Real-World Example: Trading an OTM Call Option

Suppose share ABC is currently trading at ₹1,000. You think that the stock may rise in the coming days. Instead of buying the shares directly, you decide to take an OTM call option with less risk.

• You buy a call option with a strike price of ₹1,050, with a premium of ₹10.
• Contract size: Let’s assume 200 shares
• Total cost = ₹10 × 200 = ₹2,000

Now suppose the price of ABC shares becomes ₹1,080 on the day of expiry.

• Intrinsic Value = ₹1,080 – ₹1,050 = ₹30
• Net Profit per share = ₹30 – ₹10 = ₹20
• Total Profit = ₹20 × 200 = ₹4,000

In this way, OTM call options can be a good choice for traders who want to capture a big move with less money, but correct estimation and timing is very important in this.

Risks and Limitations of OTM Calls

Trading in OTM calls can be risky due to the following reasons:

• Usually OTM options become worthless on expiry : OTM call options do not have intrinsic value, and if the price does not go above the strike price by expiry, then this option becomes worthless.
• Rapid effect of Time Decay : OTM options values are based only on time value. As the expiry approaches, the premium decreases rapidly, due to which the value can almost vanish.
• A big price move is necessary for profit : Profit will be made only when the price of the underlying asset goes above the strike price + premium. This big move is not possible every time.
• Buying more quantity can be dangerous : Because of the low premium, new traders often buy a large quantity of OTM options, which greatly increases their risk. In a sideways market, the entire investment can be lost.

Key Metrics to Watch Before Buying OTM Calls

Some of the key metrics to look at before buying OTM calls are listed below:

• Implied Volatility (IV) : IV shows how much volatility is expected in the market. When IV is high, the premium of OTM call options becomes expensive. Buying OTM calls at high IV can make it even more difficult for you to reach the breakeven point.
• Delta : The delta of OTM call options is very low (between 0.1 and 0.3), that is, the effect of changes in the price of the underlying asset is reflected slowly on the premium. This makes it difficult to get quick profits.
• Volume and Open Interest : In an option with low liquidity, both entry and exit can be difficult. Always choose options that have both good volume and open interest.
• Time till Expiry : If the expiry is very close, time decay can rapidly reduce the premium. It is better to choose a slightly farther expiry, especially if you are expecting a directional move.

Read Also: Difference Between ITM, OTM, ATM in Call and Put Options

Conclusion

OTM call options offer the potential for large gains at a relatively low cost, but success depends on accurately estimating the time, direction, and volatility of the market. They are best suited for traders seeking high potential returns with limited upfront risk. However, using them without a clear strategy can be dangerous. Always analyze market data, price movements, and time to expiry before entering a trade. When used wisely, OTM calls can not only protect your capital but also deliver substantial profits at the right moment. However, it is essential to consult a financial advisor before trading in options.

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