Mastering Derivatives: Should you trade deep OTM options?

Last week, we discussed market wide position limits (MWPL) and how it impacts your trading in derivatives. This week, we address why many brokers do not allow their customers to trade deep out-of-the-money index options (calls and puts) and whether such restriction is a cause for concern.

Higher risk

In addition to MWPL discussed last week, NSE applies several other rules to control excessive build-up in open positions on futures and options on an underlying. One such rule is the restriction on the open position in index options for each broker. This is set at 500 crore or 15 per cent of the total open interest on all option strikes on the index, whichever is higher. Brokers with large customer base prefer to use their maximum open position limit for tradable option strikes. Hence, the restriction in taking long positions in deep OTM options.

It is optimal that you do not trade such deep OTM options. Why? Suppose you want to buy the next week expiry (March 24) 17200 call on the Nifty Index. The call trades at 93 points with the index at 16630. This option has a delta of 0.23 point. That means the option price could change by 0.23 point for every one-point increase in the Nifty Index. But with each passing day, the option could lose nine points because of time decay.

If the Nifty Index moves to, say, 16900 five days later, the 17200 call could be worth 112 points, just 19 points increase despite 270-point increase in the underlying! And if the Nifty Index moves to 16900 a week after you buy the option, the 17200 call could lose value despite the increase in the index. This is because delta, which favours the long position, is significantly lower than theta, which hurts the long position. That is, the increase in the option price because of the change in the underlying will be significantly lower than the decline in option price because of passage of time.

So, why do individuals buy deep OTM options? One reason is regret aversion leading to loss aversion. We hate taking losses. Now, at-the-money (ATM) option and near ATM options have higher absolute premiums. A loss on these options could lead to greater regret. Buying deep OTM options could moderate regret, given their lower price. Also, most individuals realise that such options are like playing the lottery — winning generates significant return, but losses are small. Unfortunately, this strategy is not optimal on a continual basis. Long positions in deep OTM options are more likely to generate losses than gains. Can you (emotionally) take frequent losses before you make such large gains?

You should give more time for deep OTM options, especially puts, to become ATM, if not ITM. Besides, there is no liquidity even if your broker were to allow trades in such deep OTM options. Most of the volumes are concentrated on near-term expiry. At the time of writing this article, the change in open interest (an indicator for future liquidity) in 16700 strike was 1,410 contracts for near-month option, 16,290 contracts for the near-week option and 683 contracts for the next-week option. The upshot? It would be optimal to trade within two tradable OTM strikes on the Nifty Index.

Optional reading

Your objective should be to trade options based on breakout or expected reversal of the underlying. Trading options for breakouts (breakdowns) involves setting up long calls and call spreads (long puts and put spreads). Trading expected reversals involves buying calls (puts) in anticipation of a price reversal after a downtrend (uptrend).

Take note

Delta favouring the longs significantly lower than theta

Options trading based on breakout or expected underlying reversal 

Buying OTM calls may not generate returns, given its low delta

Buying OTM calls may not generate returns, given its low delta. Buying OTM puts may be optimal for betting on market crashes. It would be appropriate to use long-term options for this strategy. Unfortunately, long-dated options (half-yearly series) on the Nifty Index are illiquid.

(The author offers training programme for individuals to manage their personal investments)

COMMENT NOW