Buying Options helps traders participate in the stock market moves at an extremely low capital requirement. For instance, to participate in a bullish view on Nifty for the weekly option with ATM strike will today cost as low as Rs 9,750 (Strike: 14900, Premium: 130.7, Lot size: 75), that’s not even 5 digits.
This attracts lots of retail investors to participate in buying option strategies and to further reduce costs. Very often they resort to buying Out of the Money (OTM) options which are generally extremely low premium, even though buying an OTM option still lets you participate in the view but the payoff may not be practically lucrative.
Have you ever bought a lottery ticket? A lottery ticket with jackpot prize of Rs 1 crore sold for Rs 10 will obviously have an extremely low chance of winning. Similarly, buying OTM options may sound cheap in terms of initial capital investment but also bring the draw-back of low probability of winning. Having said this, if you did win a lottery jackpot with Rs 10 as an investment that’s a huge return.
So now the question arises, should you or, should you not buy OTM options? There cannot be a Boolean answer. A right knowledge of when to buy OTM options and when not, can provide an edge to place your trades right and increase your winning probability.
Are OTM options really cheap? Understanding OTM option
OTM options may look cheap with an absolute price perspective but it is mostly not what it looks like. Implied volatility of an OTM Put option will almost always be higher than the ATM which means buying OTM puts are expensive.
Whereas for calls due to the inverse correlation of IV (implied volatility) with underlying, for the first few near OTM strikes the IVs may be lower and then beyond a point for far OTM strikes will start increasing. So, our first take-away is that buying OTM calls are better off than buying OTM puts naturally from a risk perspective.
Delta of an option can act like probability of the option expiring in the money so a delta of between 0.5 to 0.3 should be a good range to choose and OTM option, anything beyond that might be a gamble.
Evaluating your forecast
It all starts with a forecast where you first need to establish a view on the underlying, this article is not intended towards how to create a forecast but there are several papers on the web for learning to create one, you could use technical analysis or derivative data analysis to create a short term forecast.
After you have a forecast, for us to be able to decide to buy an OTM option or not, will be dependent on defining the “Intensity” of the forecast. If you expect a fast & large move in the underlying then the OTM option might provide a higher ROI but for a low intensity forecast, buying an OTM option may not yield better returns or in some instances may yield a net loss due to premium decay.
Where does time stand in Expiry
The next variable to our decision will be Time. All options have a high dependency on time as an input and so does OTM options. In early part of the expiry the theta decay is smaller and hence does not impact the OTM options much, a small underlying move will also move the OTM option to your favour in early half of expiry as the absolute delta is higher absolute theta decay but this is not the case in the second half of expiry and especially in the last few days of expiry.
As the days to expiry shrinks, the absolute theta decay starts negating any absolute delta moves creating a net loss despite the underlying moving in your favour. So, our learning is that OTM options are good to participate in early half of the expiry compared to later half.
Summary
OTM options can be helpful if used in combination with option mathematics. Buying OTM calls are generally preferred over buying OTM puts due to low IV differential. OTM options should be bought only when the underlying forecast is for a fast and large move.
Lastly, OTM options should be preferred in the first half of the expiry and as we approach expiry, we should shift our trades towards ATM or ITM options.
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