The Dangerous Lure Of Cheap Out Of The Money Options

Out of the money (OTM) options are more cheaply priced than at the money (ATM) or out of the money (OTM) options, because the OTM options require the underlying asset to move further in order for the value of the option (called the premium) to substantially increase. What looks cheap isn't always a good deal, because often things are cheap for a reason. That said, when an OTM option is properly selected and bought at the right time it can lead to large returns, hence the allure. 

While buying out of the money options can be profitable strategy, the probability of making money should be evaluated against other strategies, such as simply buying the underlying stock, or buying in the money or closer to the money options.

A call option is considered OTM if the strike price for the option is above the current price of the underlying security. For example, if a stock is trading at $22.50 a share, then the 25 strike price call option is currently "out-of-the-money."

A put option is considered to be OTM if the strike price for the option is below the current price of the underlying security. For example, if a stock is trading at a price of $22.50 a share, then the 20 strike price put option is "out-of-the-money."

There are varying degree of being OTM (and ITM). If the strike price on a call options is 75, and the stock is trading at $50, that options is way out of the money, and the price of that option will be very little. On the other hand, a call option with a 55 strike is much closer to the $50 current price, and therefore that option will cost more than the 75 strike.

The further out of the money an option is, the cheaper it is because it becomes more likely that underlying will not be able to reach the distant strike price. Likewise, OTM options with a closer expiry will cost less than options with an expiry that is further out. An option that expires shortly has less time to reach the strike price, and is priced more cheaply than OTM option with longer until expiry. OTM options also have no intrinsic value, which is another big reason they are cheaper than ITM options.

On the positive side, OTM options offer great leverage opportunities. If the underlying stock does move in the anticipated direction, and the OTM option eventually becomes an ITM option, its price will increase much more on a percentage basis than if the trader bought an ITM option to begin with.

As a result of this combination of lower cost and greater leverage it is quite common for traders to prefer to purchase OTM options rather than ATM or ITM options. But as with all things, there is no free lunch, and there are important tradeoffs to take into account. To best illustrate this, let's look at an example. 

Let's assume that a trader expects a given stock will rise over the course of the next several weeks. The stock is trading at $47.20 a share. The most straightforward approach to taking advantage of a potential up move is to buy 100 shares of the stock. This would cost $4,720. For each dollar the stock goes up/down, the trader gains/losses $100.

Another alternative is to purchase an ITM call option with a strike price of $45. This option has just 23 days left until expiration, and is trading at a price of $2.80 (or $280 for one contract which controls 100 shares). The breakeven price for this trade is $47.80 for the stock ($45 strike price + $2.80 premium paid). At any price above $47.80, this option will gain, point for point, with the stock. If the stock is below $45 a share at the time of option expiration, this option will expire worthless and the full premium amount will be lost.

This clearly illustrates the effect of leverage. Instead of putting up $4,720 to buy the stock, the trader puts up just $280. For this price, if the stock moves up more than $0.60 a share (from current price of $47.20 to breakeven of $47.80), the option trader will make point for point profit with the stock trader who is risking significantly more money. The caveat is that the gain has to occur within the next 23 days, and if it doesn't the $280 is lost. 

Another alternative, for a trader who is highly confident that the underlying stock is soon to make a meaningful up move, is to buy the OTM call option with a strike price of $50. Because the strike price for this option is almost three dollars above the price of the stock ($47.20) with only 23 day left until expiration, this option trades at just $0.35 (or $35 for one contract).

A trader could purchase eight of these 50 strike price calls for the same cost as buying one of the 45 strike price ITM calls. By so doing she would have the same dollar risk ($280) as the holder of the 45 strike price call. The downside risk is the same, although there is a greater percentage probability for losing the entire premium. In exchange for this, there is much larger profit potential. Notice the right-side of the x-axis on the graph below. The profit numbers are significantly higher than what was seen on the previous graphs.

The catch in buying the tempting "cheap" OTM option is balancing the desire for more leverage with the reality of simple probabilities. The breakeven price for the 50 call option is $50.35 (50 strike price plus 0.35 premium paid). This price is 6.6% higher than the current price of the stock. So to put it another way, if the stock does anything less than rally more than 6.6% is the next 23 days, this trade will lose money.

The following chart displays the relevant data for each of the three positions, including the expected profit – in dollars and percent.

The key thing to note in the table is the difference in returns if the stock goes to $53 as opposed to if the stock only goes to $50 a share. If the stock rallied to $53 a share by the time of option expiration, the OTM 50 call would gain a whopping $2,120, or +757%, compared to a $520 profit (or +185%) for the ITM 45 call option and +$580, or +12% for the long stock position.

However, in order for this to occur the stock must advances over 12% ($47.20 to $53) in just 23 days. Such a large swing is often unrealistic for a short time period unless a major market or corporate event occurs.

Now consider what happens if the stock closes at $50 a share on the day of option expiration. The trader who bought the 45 call closes out with a profit of $220, or +70%. At the same time, the 50 call expires worthless and the buyer of the 50 call experiences a loss of $280, or 100% of the initial investment. This is despite the fact that she was correct in her forecast that the stock would rise...it just didn't rise enough.

It is acceptable for a speculator to bet on a big expected move. The key however, is to first understand the unique risks involved in any position. And secondly, to consider alternatives that might offer a better tradeoff between profitability and probability. While the OTM option may offer the biggest bang for the buck, if it works out, the probability of a far out of the money option becoming worth a lot is a low probability.

These graphs are just examples of profit.loss potential for various scenarios. Each trade is different and option prices are constantly changing as the price of the other underlying and other variables change.