Perils of buying out of the money options

In 1972, to invest in a piece of land, the going rate in Bengaluru was roughly ₹6.6 per sq ft, and one had to shell out around ₹14,000 for the entire plot.

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”. Their entire family today is glad they decided to invest. Why wouldn’t they, after all the land is valued upwards of ₹15,000 per sq ft today and the total property is worth in excess of ₹8 crore.

If you look at it another way — what real-estate investors 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 witnessed their investment grow multi-fold.

Let us cut back to the option world. There are many traders who buy deep out of the money options with the 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 work 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, think of Greeks as the forces simultaneously acting upon the option’s premium. They play an 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 one 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 per cent to expiry ‘in the money’, which is great. On the other hand, deep out of the money (OTM) options have the lowest deltas.

Their deltas 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 per cent, 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 are very low.

When you buy a deep out of the money option, the chances of losing money paid as premium are as high as 80-95 per cent. Further, the typical trader behaviour is to buy these OTM options, especially the weekly Bank Nifty options just one or two 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 this 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.

Why do you think the real estate investment paid off? That’s because they gave their investment a lot of time and when you do that, you are also essentially working towards enhancing your probabilities as well.

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

The writer is Founder & CEO, Zerodha

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