Out Of The Money Option Buying Strategy

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If you do some research online or even ask an expert, you will find that a lot of people and experts advise against buying out-of-money (OTM) options. The reason is plain and simple. They say it has more chances of expiring worthless so you may also lose your money. They should be sold not bought. Well they are right. More often than not out of the money options expire worthless. Is that the only reason you should not buy them?

I do not agree – to some extend. If you have a well thought out strategy you can make a good profit out of them. Also out of money options have other importance too – else why are they traded? Let me put some points outright to explain:

1) OTM options are great for protection: If you have read about credit spreads, you will understand the value of buying OTM options for protection. If a spread is going against you, it is the OTM option that will bring profits and minimize your unlimited losses. In fact it is due to out of the money options that you may sleep well in the night knowing very well your max loss. Buying OTM options will limit your losses. OTM options have the same job on the iron condors as well. Buying out of the money options can be a lifesaver if you have sold in the money options.

2) OTMs double money very fast: Agreed, its easier said than done. But in my three years of experience in trading, I have seen hundreds of out of the money options doubling in value in days. (You feel bad thinking why you did not invest, isn’t it? But that’s a different topic.) I am sure you must have experienced too.

I have seen an option going from 1.00 to 3.75 in one day. Yes an increase of 375% in one day. No in-the-money option can ever match that even if there is a huge move in the underlying. But please never buy so deep out-of-money option. This is just an example that happens very rarely.

You see percentage wise, it is the out-of-money options that increase in value fast – by the way, they don’t decrease that fast. Why? Because the max they can decrease is to 0.05. If 30 days are left for expiry, an OTM with the value 2 – how fast do you think its going to decrease? Because they have nothing but time value left, the deep out-of-money options cannot decrease very fast if enough time is left. Yes enough time should be left – and that is a very important factor. I will explain later why.

3) Who is waiting till expiry anyway? Did you make any meaning out of that? If you didn’t I will explain.

Read this is important. When experts say you shouldn’t buy out-of-money options they are referring to the expiry. Yes its true that OTM options mostly expire worthless, so if you plan to wait till expiry then you are doing a huge mistake. Do not buy out-of-money options to hold till expiry. You will lose all your premium paid. Experts are right – out-of-money options expire worthless 80% of the time. But my point is who is waiting till expiry?

Let me give you a live example. Today 26-July-2013, I bought NIFTY AUG13 6400 CE (call option) for 3.5. My max loss capacity I have determined is Rs. 3500. (Note that I am not putting a lot of money at risk as this option will 90% expire worthless, I cannot be greedy.) I have bought 20 lots. Here is the math: 3.5*20*50 = Rs. 3500.00.

Nifty today closed at around 5886. There is a lot of time for the August 2013 series to expire. I need not worry. And moreover I have made up my mind not to lose more than 2500 in this trade. If this option reaches 1.00, I will close this trade. However what are the chances that this option will only decrease in value for the next few trading sessions? For that 1) Nifty has to keep going down and 2) volatility has to also keep going down. Even if Nifty goes slightly down, but volatility rises – I can make a profit.

My target is 5.5. if Nifty goes up by even 50-60 points or volatility rises I can achieve that. The profit I make is Rs. 2000.00. I am risking Rs. 2500.00 to make 2000. Isn’t that fair?

I will not update with what happened to this particular trade as it is not important. But what is important is that when you buy out of money options you should keep the following strategy in mind:

1. Never buy very deep out-of-money option. As explained earlier please do not be greedy and buy too deep out-of-money options. Yes they may also increase in value but for that the underlying has to move very fast.

2. Give your option enough time and room to increase in value. Do not buy a out of the money option in its last week of expiry. You will rarely make a profit. If you keep your stop-loss very small you are most likely to lose money every time.

3. Sometimes be prepared to lose 100% of your option premium – as you may not get time to close the trade (a huge jump against your trade) and you may not get back a comfortable amount. In that case leave the option till expiry, who knows the trend will change and you may get your money back, or you may even be in profit. Remember the first point, you should have enough time for it.

4. Do not buy options too often. Usually option buyers lose money. Yes if 80% of options expire worthless, it means option sellers are making money. Do proper research before even thinking of buying an option. Lots of people have lost lot of money buying options. This point goes for at the money (ATM), in the money (ITM) or out of the money (OTM) options. If you want to buy anyway – you should have a clear stop loss or profit booking price in your mind. You should place it in your system if you think the option price may reach there on that day.

Now you must be thinking why I bought this option? Because right now Nifty is in a bull run and it fell 200 points in three days. I am sure it will try to climb some points up in the next few days and I should get my target. No technical analysis here – just pure speculation – with risking only Rs. 2500.00. Hope you get the idea.

4. Do not spend a lot of money on buying out of the money options. As you can see I put in less that half percentage of my trading capital into buying these OTM options. Even if they expire worthless – I will not lose much. My next trade can make me money.

Remember these points and just don’t ignore out of the money options – sometimes they carry gold with them. Spot them. 🙂

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