Understanding the Utility of Buying Call/Put Options Before Expiration

When considering the purchase of call or put options prior to their expiration, especially if they are out of the money (OTM), many traders and investors wonder whether it makes economic sense. This article discusses the various reasons why an individual might choose to buy options in these circumstances, focusing on practical applications and the strategic benefits.

Strategic Applications of Deeply OTM Options

The decision to buy OTM options before expiration is not necessarily indicative of a financial enthusiast's approach but can serve several strategic purposes. Let's explore these reasons in more detail:

Trading Strategy and Profit Opportunities

For call options, the primary objective is not to own the stock directly. Instead, traders are interested in the potential increase in value for their option. Even if the underlying stock is highly unlikely to reach the strike price, the option’s intrinsic value increases as the stock price rises. This is because the option's value is sensitive to even minor price movements. If the option goes from $1 to $2, the trader has effectively doubled their investment and can sell it before expiration, yielding profits.

Example of Short Term Profit:

Suppose a trader buys an OTM call option for $1 when the strike price is well above the current stock price. As the stock price moves up, the option’s value rises. Suppose it goes to $2; the trader can sell the option for a profit of $1. The fact that the stock is unlikely to hit the strike price does not matter, as the option’s value increases with the stock price.

Protective Hedging

For put options, the strategy is similar but with the opposite intention. A put option offers protection against a decline in the stock's value. If you own a position that you want to protect, buying a put option before expiration can safeguard your investment. This is particularly useful when you anticipate a period of market volatility or a pending adverse event, such as earnings announcements or economic news.

Hedging Against Volatility:

Imagine you own a call option and are concerned about a potential sudden market decline. By buying a put option before expiration, you can hedge this risk. If the market does indeed decline, the put option will increase in value, offsetting the loss of your call option. This dual strategy allows you to maintain your position without significant risk.

Locking in Profits Through Spreads

Another strategic use of OTM options before expiration is in spread trading. A spread involves buying and selling options on the same underlying asset. For instance, you might buy a call option at a lower strike price and simultaneously sell a call option at a higher strike price. This limits your initial cost, as the premium from selling the higher strike offset the premium paid for the lower strike.

Reducing Cost Through Spreads:

This strategy is particularly useful for traders looking to limit costs while still participating in possible price movements. With spreads, you might still profit from smaller price fluctuations, albeit with limited upside potential. However, the inherent risk is capped, making it a more conservative approach.

Margin Management and Speculative Value

In certain circumstances, buying OTM options before expiration can serve as a margin management tool. An investor might buy an option near expiration to free up margin for other trading activities. Additionally, there's a speculative element where an investor might go long on relatively cheap options, hoping for a sudden market move.

Example of Margin Management:

For instance, an investor with a short put position might buy another put option near expiration to release margin and allow for other trading activities. When the underlying stock does not meet expectations, the entire position can be closed out, limiting losses to the cost of the options.

Strategic Hedging During Earnings Announcements

Another common reason to buy OTM options before expiration, especially around earnings announcements, is to hedge against significant price movements. The day of, or even just before, earnings announcements, the stock price can be highly volatile, offering opportunities for profit.

Earnings Day Hedging:

Consider Apple Inc. (AAPL) reporting earnings in the near future. An investor might buy a OTM call option (like the 210 strike for $0.10) or a put option (like the 160 strike for $0.10). Although these strikes are highly OTM, there's a potential for a significant price swing that could result in substantial gains, though such trades are speculative and not recommended without thorough analysis.

Short Term Hedge:

For individuals with short-term financial goals, buying OTM options can provide a simple hedge. For instance, a person might buy an OTM put (like the SPY 269 strike for $0.10) to hedge against a potential market crash. With a portfolio of $1 million, buying 360 of these options can protect against a 4% decline, significantly benefiting someone concerned about market volatility.

Conclusion

Buying OTM call or put options before expiration offers strategic advantages beyond simply owning the underlying asset. Whether for profit-taking, hedging, or margin management, these options can serve as valuable tools in a trader's or investor's arsenal. However, it's crucial to understand the risks involved and to conduct thorough analysis before engaging in such trades.