Buying deep out of the money options as a trading strategy, what is your opinion?

#1

I see that most options trading activity is on out of the money options. I have trader friends who swear by it and especially buying deeper out of the money options which can potentially reward a lot more. Also with Banknifty weekly options, it seems as if we can do this every week. What is your view on this?

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#2

The perils of buying deep OTM options

Last week, I visited my cousin’s house. He is fortunate enough to live in a fairly good locality in Bangalore. Like everywhere else in Bangalore, over the years, land prices in his neighborhood has shot up significantly, thereby driving the valuation of his property. Whenever I visit him, I always remind him how fortunate he is to be living in Bangalore’s prime location. However, this time around, he narrated the story behind this property.

Back in 1972, his parents were newly married and one of their acquaintances suggested them to invest in a piece of land (where they currently reside). The going rates back then was roughly Rs.6.6/- per square feet, and they had to shell out around Rs.14,000/- for the entire plot. Apparently, his parents were highly reluctant to buy this piece of land as it was way outside the (perceived) city limits. Back then, it was beyond anybody’s imagination that this area would one day considered ‘prime’.

But then, the typical investor sentiment kicked in – they thought “let’s just invest and forget it, if it ever works out, then we only stand to gain”. I’m sure, their entire family today are glad they decided to invest. Why wouldn’t they, after all the land is valued upwards of Rs.15,000/- per square feet today, valuing their property in excess of Rs.8 Cr.

If you look at it another way – what my cousin’s parents did is very similar to buying a deep out of the money option. They invested a small amount in a property outside the city limits and watched the city grow, and thereby watched their investment grow multifold.

Let us cut back to the option world. I know there are many traders out there, who buy deep out of the money options – with the exact same intention. They buy options with a hope that they can watch their ‘investment’ grow to yield an asymmetric pay off upon expiry. Nothing wrong with this thought, except that there two variables which works against them, almost all the time. Probability and time.

If you are fairly familiar with options then you may have come across ‘Options Greeks’. For those of you who are not too familiar with greeks – then think of greeks as the forces simultaneously acting upon the option’s premium. The greeks play a very important role in determining the price of the option’s premium. Greeks change during market hours and therefore the option premium.

Delta is one of the option greeks. Delta tells you how much the option premium is likely to change for every given point change in the spot price. For example if the delta of an option is 0.85, then for every 1 point change in the underlying, the option’s premium is expected to change by 0.85 points.

Besides indicating the point change in premium, the delta of an option is a great indicator of the probability of the option expiring ‘in the money’. In the above example, the option has a probability of 85% to expiry ‘in the money’, which is great. On the other hand, deep out of the money options have the lowest deltas. Their deltas are usually range between 0.05 and 0.2. This means, the probability of deep out of the money options expiring in the money is only between 5 and 20%, which is very low. So whenever you buy a deep out of the money option, whether you know it or not, your odds of making money is very low.

To put it another way, when you buy a deep out of the money option, the chances of losing money paid as premium is as high as 80 - 95%.

Further, the typical trader behavior is to buy these OTM options, especially the weekly bank nifty options just 1 or 2 days before the weekly expiry. They buy these options with an expectation that over the next 24 hours, with a great stroke of luck, the option would transition from deep ‘out of the money’ to ‘at the money or ‘in the money’.

Remember, time is never an option buyer’s friend. It always works against the option buyer. As time marches on, the option’s premium drops. This phenomenon is called ‘time decay’. The effect of time decay is especially high towards the end of expiry. So, when you buy deep out of the money option, you are not only fighting against probability, you are also fighting against time.

Going back to the real estate example, why do you think the investment paid off? That’s because they gave their investment a lot of time and when you give investments time, you are also essentially working towards enhancing your probabilities as well.

Unfortunately, both these don’t exist when you buy deep OTM options.

Unless there is a compulsive reason to believe that an underlying is going to move significantly - maybe a news event that you are expecting or a breakout/breakdown in price on momentum, it is best to stay away from buying deep out of the money options. Even more on the banknifty weekly where the time to expiry is just 7 days. The reward might be enticing, but it is essentially equal to playing lotto. :slight_smile:

Don’t forget to read the options module on Varsity.

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#3

Hi nithin sir…
For exactly same purpose I have requested to provide these 2 most imp option Greeks real-time
Kindly consider soon… Thnx :smile:

#4

superb :grinning:

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#5

Wild market spikes and crashes are admittedly rare events, but their reward is so large it offsets their infrequency.
if you have a 24-sigma event on an option that’s 24 standard deviations out of the money, your payoff is 750,000 times your bet. It is totally irrelevant whether these events happen every 20 or 50 years. Secondly, the further out of the money an option is, the more complicated it is for the human mind to calculate its properties. - Nassim Nicholas Taleb.

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#6

I sold the PUT of strike 11000 @ 20 Rs. As I know on expiry ATM and OTM values become ZERO but it shows 16.9.
How much money will I get 7520 or 75(20-16.9)?

#7

Too early to start counting the chickens.

Wait for the exchange to publish the closing settlement price, and then you can count the chickens.

https://www.nseindia.com/live_market/dynaContent/live_watch/get_quote/GetQuoteFO.jsp?underlying=NIFTY&instrument=FUTIDX&type=-&strike=-&expiry=27SEP2018

#8

@nithin if I don’t square off my position and let it go to exchange to get settled then I won’t get those trades in contract note of zerodha.
Am I right? If yes; Then how to get information about money credited/ debited to/from the account, other charges and taxes?

#9

Contract note says; It expired at the premium of 22.45 while all ATM strikes are supposed to be expired at premium “0”.
Am I wrong or I got the wrong statement from Zerodha?

#10

I am guessing you are referring to this thread on STT on expired options.

The broker has an option to not exercise 3 close to money option contracts on the exchange. We would do it only if the STT is more than the intrinsic value of the option.

In case of 11000 PE, STT would have been 0.125% of 11000x75 = Rs 1000 per lot. Or around 13 points of Nifty. Since the intrinsic value of this option was 22.45 on expiry, we exercised this. So in this 22.45, after paying 13 points as STT and other charges, you still get back around Rs 10. If we hadn’t exercised this, you would not have gotten back any money at all. So in this case of yours, you would have lost Rs 750 approximately per lot.

STT, you can see on the contract note itself.

So yeah, in gist, with close to money (CTM) contracts, we will not exercise if the premium value on close(intrinsic value) is more than STT

Edit: Sorry, just saw now that you have shorted the 11000 PE and not bought it. When you short, there is no option with the broker. You get compulsorily exercised. The only time you might not get exercised is again if STT > intrinsic value (by the opposite broker). For example, if this option expired at 10990, the intrinsic value would have been 10 and STT would have been 13 points. So most likely the opposite brokerage (the client who has bought your short puts), would not have exercised, in which case you would have got to keep the entire 10 points.

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#11

Sorry @nithin I couldn’t understand your explanation at all or couldn’t relate to my query.
As I know all OTM and ATM strikes on expiry become “0”. My PUT expired ATM So my doubt is why didn’t it become “0”?

STT is for buyers not applicable to sellers. Am I right?

#12

This is got a long history, so a long reply to you. :slight_smile:

No, you are wrong. Yes, all OTM expire worthless, because they are out of the money.

But any option with intrinsic value on expiry - which is markets above the strike for calls and below the strike for puts - then it is not 0.

So if you have shorted 11000 PE and markets close at 10977.55, then the intrinsic value is 22.45. So you as an option writer have to technically pay back this 22.45 to the buyer. That is how options work.

There is one issue with this, the settlement post expiry is considered as an exercise. Even though only cash settlement happens between the seller and buyer, it is considered as a delivery trade. Which means that STT on such a trade for the buyer of the option is 0.125% of contract (exponentially higher than 0.017% of premium if traded on the exchange).

What used to happen was, if a buyer of an option let 11000 PE expire and the market closes at 10995, he would get back Rs 5 as premium. But he’d have to pay Rs 13 as STT. We had a case where a client lost 25lks in STT on expiry for holding Rs 11000 worth of option premium. Check this thread:

Also, suggest you to read this blogpost to understand how it used to be before:

We pushed for a change with the exchanges for years. Finally, last August they introduced the concept of close to money options (CTM) and gave brokers an option to expire such position worthless. Check this thread:

So what it meant was that if a broker saw that his clients who had long options on expiry and if the STT value is more than the premium value, he could just let it expire worthless. This was to ensure that another Chirag Gupta kind of an incident wouldn’t happen. But note that it is all for option buyers. Option sellers aren’t affected by STT as it is paid when getting into the short trade. Option sellers also don’t have an option, they are obligated by definition to an exercise.

Coming back to your case, Nifty expired with the intrinsic value of 22.45. No option buyer would have opted to expire this worthless. The reason for this is, even after paying STT, he gets back 10 points. Assuming Nifty expired at 10990, an intrinsic value of 10 points (but they would have to pay back 13 points as STT) - in this case, all option buyers of this 11000 PE would have opted to expire this worthless. In which case, it would have been like expiring at 0.

Again, there might be some buyers who might by mistake opt to expire options worthless by mistake even when STT< Intrinsic value or options buyers who might exercise even if STT> intrinsic value. In all such cases, exchanges randomly assign options sellers to the buyers. So you might or might not be the one assigned.

Phew… Hopefully, you get it now. Also, make sure to read the blogpost.

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#13

Thanks for this exhaustive explanation. :slightly_smiling_face:
So I can conclude the following from the aforementioned explanation…
So no more rely on the theory of expiry which says “All OTM and ATM srikes become 0”. So now only OTM becomes “0”, not ATM strikes.
And No more STT trap. :slightly_smiling_face:
Did I conclude you correctly ? :thinking:

#14

Yes. And thinking/assuming that all at the money options expire worthless is hmm… Maybe not trade options until you are sure on the theory, risks etc. Trading in F&O is extremely risky. Suggest you to read this first.

#15

Still, I have a doubt.
My position was squared off by Zerodha automatically without my concern/permission though I had enough money to fulfill the requirement of margin.
Does Any broker has right to square off the position without clients permission?

#16

Like I said, I guess you need to first maybe learn the theory of options. Check the Varsity module.

All F&O contracts have an expiry day. On that day, everything expires, it has nothing to do with broker. Today you won’t find that yesterday’s expired contract on the exchange.

#17

Hi…@nithin Its a hypothetical situation.

  1. If I buy 1 lot of 1100 CE and let it expire 1105 (Don’t square off my position and let it go to exchange to get settled). How much Will I get/pay per share?

  2. If I sell 1 lot of 1100 CE and let it expire 1105 (Don’t square off my position and let it go to exchange to get settled). How much Will I get/pay per share?

#18

So it expired ITM of 5 rs per share, multiply 1105 by lot size to get total contract value, STT to be paid will be .125% on total contract value as you let it expire ITM, also add all other charges to it. If STT is higher than 2500 then your broker might let it expire worthless instead getting it settled.

So, in this case you have to pay 2500 per lot( 5 rs ITM and lot size 500) plus all other charges as usual, as STT is already paid when shorting you won’t be charged any STT in this case.

#19

So doesn’t matter whether I sell or Buy, If option expires ATM strike (below the next strike and above the previous strike), I have to pay money as your explanation says. Am I right?

#20

You have to pay if you have to, may be you can read varsity module on options to know more on how actually options work.