Out of the Money Options
Out of the money options are priced purely upon their potential to move into the money, Options that are far out of the money will be priced much lower than those which are close to the money, because the further out ones simply have a lower to much lower probability of moving enough to get in the money and have actual value during the life or at the end of the options contract.
While it is true that out of the money options are riskier to much riskier than in the money options, and one will lose their entire investment if the option is held and does not make it to the strike price, this doesn’t mean that out of the money options do not have their place with speculating.
The option premium is always priced into options, and when we buy an in the money option, we are paying for its intrinsic value plus the premium, where with out of the money options we’re just paying for the premium.
If the option does not perform for us, we’re going to lose the premium, and we may also lose the intrinsic value as well if we paid for it. With out of the money options, we can only lose the premium.
On this count, there is a feature of out of the money options that at least suggest lower risk, and going from in the money to out of the money and expiring worthless is certainly the worst possible outcome for an options purchase as well as the most expensive.
Since in the money options are more expensive than out of the money options, if you lose everything, it’s better to lose less than more.
The probability of the option not finishing in the money is higher if you buy it out of the money though, and that’s why it isn’t necessarily the case that out of the money options are less risky, and they usually are riskier in fact.
Drawdown Risks with Options
Risk is not only the amount we are exposed to, we also need to account for the probability of this risk. If we imagine an example where 1 in 5 option trades will finish in the money, the cumulative risk of this 80% outcome can produce bigger drawdowns than larger losses with in the money trades that fail considerably less frequently.
This is particularly the case given that the more likely a losing trade is, the more likely that we will see longer strings of these losing trades in sequence. With only a 1 in 5 chance of success, for instance, we could see strings of losses that could number 20 or more, and we need to be prepared to handle these results.
With a higher probability of success, we are going to be much more protected from longer series of losses like this, where for instance it may be unlikely that we may experience more than a couple of losses of our entire investment in the option.
Out of the money options do encompass a wide range of degrees of being out of the money, and the further an option is out of the money, the more risk there is of course for it to expire worthless and expose traders to complete losses.
The closer an out of the money trade is to being in the money, the less risk there is, and as traders we do need to manage risk well enough, lest we get seriously hurt or even go broke. While some traders speculate on options exclusively, even for a living, this is a form of trading that does need to be carefully managed, and well out of the money plays simply does not fit this profile very well.
There are plenty of traders who do look to speculate on these well out of the money options, but these aren’t the traders who tend to be successful, and tend to be more like gamblers than traders, looking to hit a big score and not really thinking that much about where they will likely end up if they aren’t as lucky as they hope they will be.
There’s just too much that is priced into options and if we are expecting a huge move upward or downward in the market, you can bet that the options market is going to price this in to a significant degree already. Therefore, your predictions don’t just have to be right, they have to be right in excess of what is already expected.
With considerably out of the money options, this excess needs to add up to a large amount even before you can cash in. The likelihood of this happening is simply not all that great, especially considering that many people buy these options more on a lark than anything, with little analysis if any.
These options can be perfect for those who are looking to hedge with them, as they are cheap and will only kick in if the big negative events that are concerning us come to pass, a market crash for instance.
It’s not that hedging with far out of the money options is necessarily a great idea, as this depends on the circumstances and the goals of the trader or investor, but they can be a good idea in certain instances, and it generally does not make sense to hedge with closer to the money options unless one plans on looking to trade them for a profit.
Hedgers are hoping that the options expire worthless though, and this is a lot like buying insurance against accidents but hoping this never happens. If you only cash in when the accidents happen, even though you may cash in pretty big, and the accidents don’t happen very often, the real accident may be the trade itself.
In the Money Options are More Like Trading Assets
In the money options are actually more of a hybrid trade, a cross between trading the asset itself and trading an option on it. In a real sense, this is exactly what this is.
In the money options does offer the ability to control more of the underlying asset than would be the case if one just traded it, and this does appeal to many traders. While this can provide a benefit, it should not be a compelling or even significant reason to trade options though.
While options do provide leverage, there are other ways to leverage trades, and while one may perhaps not be able to do it with a particular asset such as a certain stock, we still need to compare all options when we look to trade and never be married to certain markets that we just prefer on a personal level or for any reason.
In the money options and all options do have the added risk of seeing their value go down to zero, and while that can happen with any leveraged trade. You can lose more than your investment with other leveraged trades, but this does at least happen in an orderly manner, which can be well managed with the right skill set.
If a leveraged position is moving against you, you can just set a stop loss to define your risk, or exit the trade manually. Options are not that simple though, and options are very complex instruments, much more so than trading anything else in fact.
Movements in your favor with in the money options, and all options, are going to be muted, and this is due to the risk to the options seller being accounted for. As it moves our way, this increases its risk to the seller, and thus the movement will not replicate the movement in the asset but only move a percentage of it.
This is due to the time factor in options, but when we compare in the money options to trading the underlying asset directly, we can see that along the way we do not really benefit as much in terms of capturing the full move, although if we hold the option to expiry this all evens out because there’s no time factor then.
We may therefore need to ask ourselves why we are paying this price with these options, which may or may not make sense for us, as opposed to knowing why we pay it with out of the money options, because we are placing longer shot bets and this is the only way to do it.
Just like we need to examine whether those longer shot bets should actually be placed, if they really make sense, we also need to wonder whether in the money options are the best use of our trading funds. Perhaps in both cases the answer may be that it is, but we won’t know this without a lot of thinking.
Many traders do well with options but they are the ones that have done the right amount of thinking.
Editor, MarketReview.com
Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.
Contact Eric: eric@marketreview.com
Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.
