Deep Out of the Money (OTM) Options: A Comprehensive Guide

Deep Out of the Money (OTM) Options: A Comprehensive Guide

Definition

Imagine you're betting on the price of a stock. A Deep Out of the Money (OTM) option is like betting on a very long shot. It's a type of options contract where the strike price (the price at which you can buy or sell the underlying asset) is far away from the current market price. For a call option, this means the strike price is significantly above the current market price, and for a put option, the strike price is significantly below the current market price.

Key Takeaway: Deep OTM options provide significant leverage but are highly risky due to their low probability of profit.

Mechanics

Let's break down how this works. Options contracts give you the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specific price (the strike price) on or before a specific date (the expiration date). The further the strike price is from the current market price, the deeper OTM the option is.

Deep OTM Call Option: Strike price is substantially higher than the current market price.

Deep OTM Put Option: Strike price is substantially lower than the current market price.

For example, if a stock is trading at $100, a deep OTM call option might have a strike price of $120 or $130, while a deep OTM put option might have a strike price of $70 or $60. The price of these options is primarily determined by two factors: intrinsic value and extrinsic value (also known as time value).

• Intrinsic Value: The difference between the strike price and the current market price. Deep OTM options have no intrinsic value because the strike price is unfavorable. They are worthless if held until expiration.
• Extrinsic Value (Time Value): This is the potential for the price of the underlying asset to move enough before the expiration date to make the option profitable. This value erodes as the expiration date approaches, a phenomenon known as time decay.

Trading Relevance

Why would anyone buy a deep OTM option, given its low probability of success? The primary allure is leverage. A small investment can control a large amount of the underlying asset. If the underlying asset makes a substantial move in the right direction, the value of the option can increase dramatically. This is because the option moves from being OTM (worthless at expiration) to In The Money (ITM) which has intrinsic value. This means a trader can generate a high return on their initial investment. This strategy is also used in volatility trading.

• Long Shot Strategy: Traders purchase deep OTM options with the hope of a large, unexpected price move in the underlying asset. This is often used when anticipating a significant event, like an earnings report or a product launch.
• Hedging Strategies: Deep OTM options can be part of a broader hedging strategy. For example, a trader with a large position in a stock might buy deep OTM puts to protect against a catastrophic price decline. This offers insurance against a large loss, although the probability of it being triggered is low, the potential payoff is significant.
• Volatility Plays: Deep OTM options are also used to bet on increased volatility. If a trader believes that the price of the underlying asset will move significantly, but they are uncertain of the direction, they might buy both deep OTM calls and puts. This is a high-risk, high-reward strategy.

Risks

Deep OTM options are inherently risky.

• Time Decay: The value of an option erodes as it approaches its expiration date. This is especially detrimental to deep OTM options, as they have little to no intrinsic value to begin with. Time decay accelerates as the expiration date nears.
• Low Probability of Profit: The strike price is far from the current market price. The underlying asset must make a significant move for the option to become profitable, which is less likely to occur.
• High Leverage: While leverage can amplify profits, it can also magnify losses. A small adverse price movement can quickly render the option worthless, leading to the loss of the entire investment.
• Volatility Dependence: Deep OTM options benefit from increased volatility. If volatility decreases, the option's value will decline, even if the underlying asset's price moves in the desired direction.

History/Examples

Deep OTM options have been used in various trading scenarios throughout history. Like Bitcoin in 2009, when the value was extremely low, early adopters of crypto might have purchased extremely cheap call options, betting on a large price increase. Today, traders might use them when anticipating a major event, like a merger announcement or a regulatory decision. For example, a trader might buy a deep OTM call option on a biotech stock before a crucial clinical trial result is released. If the trial is successful, the stock price could surge, and the option could become very profitable. Conversely, if the trial fails, the option would likely expire worthless.

Another example is the use of deep OTM options during periods of extreme market volatility. During the 2008 financial crisis, traders used deep OTM puts on financial stocks to bet against the market. While risky, this strategy could have yielded substantial profits if the market had continued to decline. Similarly, in the crypto markets, traders often use deep OTM options to speculate on the price movements of volatile assets like Bitcoin and Ethereum. These strategies are high-risk, high-reward plays that require a deep understanding of options trading and risk management.