Options is Gambling or Not?
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.
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.
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.
To Know Details contact us on
amolrandive71081@gmail.com
Thanks and Regards.
Amol R.
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