Understanding Deep OTM Options in Options Trading: Strategies and Profits
Options trading is a complex but fascinating domain, especially when it comes to fully understanding the nuances of out-of-the-money (OTM) options. Many traders often mistakenly categorize a cross-section of options as 'deep OTM.' However, this is a misconception. There are no 'deep' OTM options. The terminology 'way OTM' is more accurate and provides a clearer understanding of these instruments.
Way vs. Deep OTM: Defining the Terms
When an option is far beyond the current market price of the underlying asset, it is referred to as 'way OTM.' Conversely, an option that is deeply in the money (ITM) is high-priced and has significant delta value. Delta, in this context, refers to the sensitivity of the option price to changes in the underlying asset's price. Delta values for deeply ITM options are closer to 1, indicating they are more reactive to the underlying asset's price movements. On the other hand, delta values for way OTM options are close to 0, meaning they are minimally affected by price fluctuations of the underlying asset.
Conceptualizing these terms can be challenging for beginners, and it is crucial to maintain consistent and clear terminology. For instance, any strike price significantly distant from the current stock price will have both way OTM options and deep ITM options simultaneously. For example, if Tesla (TSLA) is trading at $220 per share, the 280 strike price will have way OTM calls and deep ITM puts. Conversely, the 160 strike price will have deep ITM calls and way OTM puts.
Stock Options Selling Strategy: An In-Depth Look
Several traders, including myself, follow a stock options selling strategy, particularly put selling for stocks not currently held in their portfolios but that have potential inclusion. When implementing this strategy, it is advisable to target strikes that are only two or three ticks away from the current market price (CMP), making them mildly OTM rather than deeply OTM. This strategy aims to balance risk and reward, with the intention of locking in a fluctuating premium.
For example, if I believe that Tesla's price might drop significantly, I may opt to engage in put selling at a strike two to three ticks below the current market price. If the stock remains static or shows minor fluctuations, the premium received remains intact, providing a consistent income stream.
However, if the stock experiences a larger drop, the losses become more pronounced. In such cases, I may choose to let the contract get assigned, paying the entire contract value. This move is not as dire as it seems; in fact, paying the contract value often results in a smaller loss compared to holding the underlying asset. This strategy allows for a more controlled risk profile and provides opportunities to benefit from price drops without incurring heavy losses.
Conclusion and Final Thoughts
Understanding the distinction between way OTM and deep OTM options is essential for traders, providing a clearer framework for making informed decisions. While the distinctions may seem subtle, they significantly impact the behavior and value of options. By maintaining precision in terminology and applying well-thought-out strategies, one can navigate the complex world of stock options trading more effectively.
References
[To be filled with relevant citations or references to further readings on the topic]