Some individuals prefer to buy deep out-of-the-money (OTM) Nifty puts. Their objective is to buy at low absolute prices hoping to make handsome gains if the market declines significantly. This week, we discuss whether buying deep OTM Nifty puts are optimal.

Crash gains

Think of deep OTM puts as ones that have low probability of expiring in the money (ITM). If we loosely interpret delta to mean the probability of an option ending ITM, we can define deep OTM puts as ones with delta of about -0.10. This means the option has only a 10 per cent chance of expiring ITM. The delta of a put has a minus sign to indicate that a put moves in the opposite direction to the underlying. With the Nifty Index at 17783, the next week 17400 put is deep OTM with a delta of -0.11.

If you were to buy the May 17400 put on the index, then the probability of the option ending ITM is higher. That is, longer the life of the option, greater the chances of an option ending ITM. For instance, the May 17400 put has a delta of -0.22, a probability of ending ITM that is twice greater than the same strike next week expiry. Therefore, an option can be considered deep OTM based on two factors — how far the strike is from the underlying’s current price and the time to expiry of the option.

Option moneyness
An option can be considered deep OTM based on how far the strike is from the underlying’s current price and the time to expiry

The question is: Is it optimal to buy deep OTM Nifty puts? The argument is relevant because such puts can generate handsome gains if the Nifty Index were to crash. Consider the May 17000 Nifty put that has a delta of -0.10. It is possible for the index to decline by more than 783 points by May 25 for the 17000 May put to become ITM. But what if the event does not happen and the 17000 put expires worthless? What if you buy deep OTM puts continually only to lose money frequently? To reduce the possibility of frequent losses, look for potential bull exhaustion after a continual uptrend. One such indication could be four or more consecutive green candles on the weekly Nifty chart. Note that the chances of the trade failing to generate gains is still high because of the moneyness of the option (deep OTM).

Optional reading

A deep OTM Nifty put will generate handsome gains when the market crashes, an infrequent event. This means you could have a series of losses before you generate gains. It is moot if a trader will pursue a strategy that gathers losses for consecutive months in the hope of making gains later. Note that for the purposes of market surveillance, the NSE defines a deep OTM option as a strike that is 30 per cent away from the current underlying price. While strikes so far away on equity options may be available, though illiquid, it may be unavailable on the Nifty index.

The author offers training programmes for individuals to manage their personal investments

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