Hello, options traders! I post this article to try to answer, why you should consider using out-of-the-money options. This is a question that I get all the time. and it’s a really good one.
Most traders don’t want to deal with out-of-the-money options,
They’re like a lottery ticket,
You’re just going to lose your money
There’s a lot of truth to that but you have to understand that options are tools and there are times when we might want to use these.
if there was absolutely no reason to ever buy or sell an out-of-the-money option. they just simply wouldn’t exist.
A better approach to options trading is to say when are they appropriate. Like all option trading decisions, it depends on your assumptions.
What Does OTM Mean? Out of the Money Defined
An option contract is considered “out of the money” if it has no intrinsic value, i.e., if its owner would pay more than the current market value for stock upon exercise (in the case of a call option) or sell a stock for less than the current market value (in the case of a put option).
In other words, a call option is out of the money if its strike price is higher than the spot (market) value, and a put option is out of the money if its strike price is lower than the spot price.
Table of content
- What happens if your option is “out of the money”?
- Is it better to buy out-of-the-money options?
- Why do people buy out-of-the-money options?
- What happens when an option is “out of the money”?
- Real example (Explained)
- Conclusion
What happens if your option is “out of the money”?
Let’s take a look at what those might be and why it might be beneficial to use out-of-the-money options.
Remember, options are about trade-offs. they’re simply tools. It’s like reaching a toolbox to pull out a tool, how can you say that one is better than another?
It depends on what you’re trying to do, and that’s the way you have to approach options trading.
Every single expiration date that you choose, strike price, and strategy, all create different risk profiles.
You can’t say that one dominates another for all different stock prices. Remember no strategy is better than another. The thing that you want to do is to find the trade-offs that are best for you.
For that particular trade and that’s when you’re going to have better success.
Is it better to buy out-of-the-money options?
Let’s take a look at the benefits of out-of-the-money options. First of all, I think everybody kind of understands that you can control far more shares.
Benefits of out-of-the-money options
Looking for an at-the-money option is much more expensive than “out of the money”.
For instance trading OTM for $3 or $5 or an ATM option that might be $10 or $20.
An out-of-the-money option obviously for the same money I can control far more shares or even for less money. I can still control far more shares.
The problem is OTM option has a greater chance of it to expire worthless.
It doesn’t necessarily mean it’s bad. if that’s part of your outlook for these conditions.
That would certainly warrant an out-of-the-money option then this is something have to live with.
we have to understand they are low probability. So what’s the benefit that we get even far bigger than controlling more shares?
It’s kind of a hidden benefit, and prices accelerate far more than for in the money or at the money.
When an options contract is out of money, it lacks intrinsic value.
Why do people buy out-of-the-money options?
For a buyer this is a big hidden benefit. and for the seller, it’s actually a hidden risk.
but for the buyer, this is a big plus.
We also benefit from what’s called the Trump efficacious effect,
It’s just this idea that all options become more “at the money” as volatility increases.
Deep in the money is going to start behaving more like an at the money.
In the money options are going to start behaving more like at the money.
Out-of-the-money options will start behaving more like at the money.
and that means all of those deltas are going to get compressed towards 50. everything starts to converge toward at the money strike.
Think about this… which strike has the highest extrinsic value? or time value?
The answer is: it’s at the money options.
Playing “out of the money” by buying puts while the stock price is crashing. The puts are now going to become relatively speaking more towards “at the money”. and for that, you will get this big explosion in price just from this Trump effect.
What happens when an option is “out of the money”?
Like all strategies, it depends on our assumptions. Traders who are maybe playing breakdowns. that’s where the stock or the index is going to have a sudden sharp pullback.
Meaning we are looking for fast aggressive moves in the stock. part of our assumption.
What is the right tool that fits? the problem with this is that we have to be correct about the direction, the magnitude (meaning how big is that movement), and the speed when is it going to happen.
It’s a very low-probability trade,
But if this is part of your outlook then put all of that into your corner. don’t go buy an expensive “in the money” option because you think it also might drift slowly.
Pick a side and stick with it. If this is true that we’re expecting a fairly big breakdown we should also be expecting spikes and volatility.
But how often do you see a stock goes from 100 to 80 that volatility doesn’t just jump the roof? We can put that in our corner as well. The Trump efficacious effect and so if these are the assumptions: the out-of-money put could be a perfect tool.
Real example (Explained)
Let’s choose a stock trading for $100. (ATM)
ATM put, volatility change
it’s an at-the-money strike, and for these prices, I used 30 days to expiration and 2% interest rates. so if I start off with volatility at 20% the pricing model says a
$100 call = $2.37
$100 put = $2.21
Notice these strikes are the same as the current stock price. these are at-the-money options but what would happen if I doubled volatility from 20% to 40%? what’s gonna happen to these prices?
Well here’s what I’ve done we’ve increased the volatility to 40%. we’ve kept all of the other factors the same. now:
$100 call = $4.65
$100 put = $4.49
Notice what happened the $100 “call” went from $2.37 to $4.65 roughly a double. and the $100 put went from $2.21 to $4.49, again roughly a double.
so double the volatility (holding all other factors the same) we are basically going to double our option prices. it’s not going to be an exact double but it’s going to be pretty close.
There’s a side note to this caveat that you can’t continue to double the volatility and expect the prices to always double you’re going to reach a limit.
You are basically going to double those option prices every time you double volatility.
What happens if we use out-of-the-money options so for this example?
OTM put, volatility change
I’m going to assume the stock price is 110.
VOL = 20% (30 days to expiration 2% interest rates)
$100 put = $0.11
How many put options could you buy for 11 cents?
This is the first obvious benefit that we can just simply control far more shares. but now let’s look at the hidden benefits of what happens if we double volatility from 20 percent to 40.
If I do that this $100 put = $1.33
we don’t change the stock price, we don’t change interest rates and we haven’t changed anything. we have just doubled volatility.
The outcome is not a double like it was in the previous screen, this is now 12 times your money. so if you put in $1,000 over here and you were correct just that the volatility spiked even if the stock didn’t move that’s now worth $12,000.
OTM put, volatility, and direction
Let’s say that you’re also correct that the stock actually falls. normally the order would be that the stock falls first and that causes the spike in volatility but the order doesn’t really matter mathematically.
Stock = 105
Volatility at 40%
$100 put = $2.55
Notice something else is really interesting here, this option is still out of the money the stock went from 110 to 105 and it’s a $100 put.
you don’t really need to be totally correct about the magnitude. It doesn’t necessarily need this put to become in the money to make a lot of money from the trade, but you would need to be correct about the speed and definitely need the volatility to make a fairly quick spike.
We pay 11 cents and it’s now trading for $2.55 that’s now 23 times on our money. if you put $1,000 in that’s now worth $23,000.
Conclusion
This right here is the big benefit of using out-of-the-money options.
How often do we get big spikes like this in the markets? Check out the VIX.
VIX from 1990 to 2022 and you can see we’ve had a lot of spikes, the average during this time has been about it’s under 20%. the low is about 10% tens and the high was 2021 (Covid-19) went up to about 80.
You can see that it’s very spiky, we can sit flat for long periods of time and then get these massive spikes and those are beautiful times four out of the money options.
If we zoomed right around 2008-2009 just a matter of months, it went from 20 to 80, It’s a huge jump in volatility fairly in a short time.
The whole idea kind of lends itself to some really interesting strategies even for long-term investors.
I hope this at least gives you some insight into why you might want to consider using out-of-the-money options the answer is you must be expecting fast aggressive moves that’s the first and if you’re also expecting a spike in volatility which normally comes from playing the downside then that is just an added bonus.
if you’d like to learn more about options trading please check out the “Is covered call a good strategy?” or “Options trading for beginners“