Selling Out of Money (OTM) Options Strategy with Expiry, Example, Expiration, Delta & Settlement
Option Basics
An option to buy an underlying asset is a call option, while an option to sell an underlying asset is called a put option. A trader may purchase a call option if they expect the underlying asset's price to exceed the strike price before the expiration date. Conversely, a put option enables the trader to profit on a decline in the asset's price. Because they derive their value from that of an underlying security, options are derivatives.
An option can be OTM, ITM, or at the money. An ATM option is one in which the strike price and price of the underlying are equal.
Out-of-the-money options are more cheaply priced than in-the-money (ITM) or in-the-money options because the OTM options require the underlying asset to move further in order for the value of the option to substantially increase. Out-of-the-money options are ones whereby the strike price is unfavourable when compared to the underlying stock's price.
In other words, out-of-the-money options don't have any profit embedded in them at the time of purchase.
"Out of the money" (OTM) is an expression used to describe an option contract that only contains extrinsic value. These options will have a delta of less than 50.0.
An OTM call option will have a strike price that is higher than the market price of the underlying asset. Alternatively, an OTM put option has a strike price that is lower than the market price of the underlying asset.
You can tell if an option is OTM by determining what the current price of the underlying is in relation to the strike price of that option. In Simpler terms, Out of The Money Call Option is any option with a strike price that is above or higher than the current value or price of the stock. For example, at the time of writing Nifty is at 8109. So, any strike above 8100 is Out of The Money for Call Options. For example, 8150, 8200, 8250, 8300 etc are all right now OTM – Out of Money.
Out of The Money Put Option is any option with a strike price that is below or lower than the current value or price of the stock. For example, at the time of writing Nifty is at 8109. So, any strike below 8100 is Out of The Money for Put Options. For example, 8050, 8000, 7950, 7900 etc are all right now OTM – Out of Money Put Options.
However, a significant move in the underlying stock's price could bring the option into profitability. Since the probability is low that the stock could make such a dramatic move before the option's expiration date, the premium to buy the option is lower than those options that have a higher probability of profitability.
What looks cheap isn't always a good deal, because often things are cheap for a reason. That said, when an OTM option is properly selected and bought at the right time, it can lead to large returns, hence the allure.
While buying out of the money options can be a profitable strategy, the probability of making money should be evaluated against other strategies, such as simply buying the underlying stock, or buying in-the-money or closer to the money options.
Being out of the money doesn't mean a trader can't make a profit on that option. Each option has a cost, called the premium. A trader could have bought a far out of the money option, but now that option is moving closer to being in the money. That option could end up being worth more than the trader paid for the option, even though it is currently out of the money. At expiration, though, an option is worthless if it is OTM. Therefore, if an option is OTM, the trader will need to sell it prior to expiration in order to recoup any extrinsic value that is possibly remaining
OTM options may be contrasted with in-the-money (ITM) options.
What are Deep Out of The Money options?
Those that are pretty far, so far that chances of reaching that option strike for the underlying stock is nearly impossible within the expiry.
In the above example this person – a CA student, has bought a 8900 Call. So, to make a reasonable profit Nifty has to move at least 8300+ within next few days for this option to at least double in value. In fact, if it goes till 8900 and does not cross 8900 by July expiry then also this option will expire worthless. All money gone.
So, what’s the major problem buying Out of The Money Options?
While out-of-the-money options are typically viewed as the more "aggressive" of the two, there are potential upsides to purchasing these types of contracts. For one, the cost to buy an OTM option is lower than the cost to buy an ITM option. This is because at the time of the purchase, OTM contracts have no intrinsic value. So, while the potential for a 100% loss is greater, the cost to enter the trade is lower.
Lower Probability of Success
Since this option already has no intrinsic value, it only has extrinsic time value. The market would have to move above the strike price and exceed that by the amount that you paid for the option just to break even.
Only after you exceed that break even point do you even begin to make money.
Hence the probability of success is well <50% – especially when assuming a normal distribution in returns of an underlying.
OTM options are best used when you expect a big move – such as from some corporate takeover announcement, big earnings beat or miss, or a trending move.
More Time Decay
All call options lose money for each day that the market does not move up. This is particularly pronounced in short-dated options that are 2 weeks or less.
It is even more pronounced in out-of-the-money call options, since these options have no intrinsic value. Each day the market does not explode higher, the time value of these options drift lower and lower until it goes to 0 at expiration date.
It is for this reason, that most pros end up selling out-of-the-money options, rather than buying them.
You are racing against time therefore taking more risk.
Like an option 10% or more away has 90% of chances of expiring worthless. So in other words the chances of falling in this trade is 90% or more. Why take so much of risk to make money when other better ways are there in options trading?
Even if correct if a swift move doesn’t come time will not allow these options to move fast.
Assuming a 1% move up comes in 3-4 days but do not forget that there is time value in options that keep eating premiums of all options. So that far OTM options may still show negative return or be in the same place they were 3-4 days back.
You cannot compound your money with these kinds of very risky and dangerous strategies.
This person is taking a risk of only 1000 rupees buying that risky option. If he makes a 10% profit, he makes 100 rupees and if it expires worthless he losses 1000. That is it. But ask him to buy this option for 40-50 lakhs. Even after 10 successful trades his mind will tumble before risking 40-50 lakhs buying a deep out of the money option.
Buying OTM option is NOT trading its gambling
People buy OTM options because they think it’s cheap, and can easily be doubled if a move comes. What they forget is that move has to come in their direction very fast. Even if 3-4 days goes away forget the profits – you will book your losses and come out.
Let me take an example. Assuming you bought a deep OTM option for 5 worth Rs. 5 lakhs. That night you will not be able to sleep well. Next day that option opened at 4. You are sitting at a loss of 1 lakh. You will surly lose patience and book 1 lakh loss and come out – only to see an hour later that the option is trading at 6. You then hit yourself hard for booking a loss. In frustration you buy that option again for 4 lakhs. But within 1 hour that option is back at 4, you again get frustrated and again book losses. This is life of an OTM option buyer.
Options, whether used to ensure a portfolio, generate income, or leverage stock price movements, provide advantages over other financial instruments. Several variables influence an option's price or premium. Implied volatility is an essential ingredient to the option-pricing equation, and the success of an options trade can be significantly enhanced by being on the right side of implied volatility changes.
Degrees of OTM and ITM
Degrees of being OTM vary from case to case. If the strike price on a call option is 75, and the stock is trading at $50, that option is way out of the money, and the price of that option would cost very little. On the other hand, a call option with a 55 strike is much closer to the $50 current price, and therefore that option would cost more than the 75 strike.
The further out of the money an option is, the cheaper it is because it becomes more likely that underlying will not be able to reach the distant strike price. Likewise, OTM options with a closer expiry will cost less than options with an expiry that is further out. An option that expires shortly has less time to reach the strike price and is priced more cheaply than OTM option with longer until expiry.
OTM options also have no intrinsic value, which is another big reason they are cheaper than ITM options. Intrinsic value is the profit from the difference between the stock's current price and the strike price. If there is no intrinsic value, the premium of the option will be lower than those options that have intrinsic value embedded in them.
On the positive side, OTM options offer great leverage opportunities. If the underlying stock does move in the anticipated direction, and the OTM option eventually becomes an in-the-money option, its price will increase much more on a percentage basis than if the trader bought an ITM option at the onset.
As a result of this combination of lower cost and greater leverage, it is quite common for traders to prefer to purchase OTM options rather than ATM or ITM options. But as with all things, there is no free lunch, and there are important trade-offs to consider. To best illustrate this, let's look at an example.
The Bottom Line
It is acceptable for a speculator to bet on a big expected move. However, it's important to first understand the unique risks involved in any position. It's also important to consider alternatives that might offer a better trade-off between profitability and probability. While the OTM option may offer the biggest bang for the buck, if it works out, the probability of a far out-of-the-money option becoming worth a lot is a low probability.
In conclusion, the choice between in-the-money and out-of-the-money options comes down to a matter of preference. Each alternative offers pros and cons, so it's up to you to decide which features are most appealing.
Plus, bear in mind that your choice may change with each trading opportunity. When you're forecasting a quick, drastic rise in the underlying stock, it might make more sense to buy out-of-the-money options. Conversely, if you anticipate a relatively modest rise over a longer time frame, you may prefer to trade in-the-money options.
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