Last week, we discussed the optimal path to derivatives trading. To recap, we suggested that you start with the spot market, then move to the futures market before trading options. Our suggestion was based on loss aversion that individuals suffer from. This week, we discuss how regret aversion can affect performance of option traders.

Trading Vs Lottery

Trading requires skill and luck. You must take risky bets based on your view on the underlying. Typically, your view is established from reading chart patterns. Importantly, you must determine the upside potential against the risk of loss (reward to risk ratio) before you enter a trade. Unfortunately, many individuals do not adhere to this principle.

The upshot? Many traders buy deep out-of-the-money (OTM) options because such strikes have low premiums. The rationale is that the risk capital is small. This is a way of moderating future regret (regret aversion) in the event the trade turns into a loss. The strategy, however, is not optimal. Why?

Deep OTM options are the ones that are several strikes away from the current spot price. Such options carry only time value. Now, the time value of the option becomes zero at expiry. Also, the delta of these options is small (less than 0.50 tending towards zero). This means that the option will move slowly for a one-point change in the underlying. That is, if the (implied) delta of a call option is 0.20, the option price will change by 0.20 point for a one-point increase in the underlying. Approximately, this can also be inferred as a 20 per cent probability of the option ending in-the-money.

Combine time decay and the small delta and you have low odds of winning on this trade unless you expect the underlying to move sharply in your preferred direction. But if you expect the underlying to move sharply, you should be betting on at-the-money (ATM) or near ATM option.

There is one aspect of buying deep OTM options that is important to note. OTM puts on the Nifty Index, for instance. This position generates high intrinsic value when the underlying crashes. From a statistical perspective, buying OTM puts to protect tail risk or market crashes is considered good. This is because this strategy is a positively skewed returns distribution. That is, you could incur frequent small losses and infrequent large gains. The issue is that you are unlikely to persist with the strategy after incurring a series of losses from expired options. The bottom line? It is best to avoid deep OTM options, even if it is tempting to buy them because they are cheap based on absolute premium.

Optional Reading

Deep OTM options often tend to have high implied volatility. Why? Individuals typically buy deep OTM options in anticipation of a sharp price increase in the underlying. Now, greater demand for an option could lead to increase in its price. When an option price increases during a trading day, there will be no change in time to expiry of the option. And if the change in the underlying price is marginal, the increase in option price leading to increase in time value will translate into higher implied volatility as there will be insignificant change in delta. Note that the speed at which time value of an option moves towards zero at expiry depends on whether the implied volatility increases or decreases.

The issue is that your chances of making losses are high if you buy deep OTM options with high implied volatility. For one, the option price will fall rapidly as the high implied volatility could eventually decline, accelerating time decay. For another, even if the underlying moves up, gains from change in delta will be small compared to losses from time decay. This is true when the option continues to be OTM despite the underlying moving up.

(The author offers training programs for individuals for managing their personal investments).

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