There is a saying that OTM options are for gamblers especially those who are blindly betting on cheaper options. And this post explores how one can effectively manage their positions using OTM Options and when to trade OTM Options.
The positive side of OTM options
1)OTM options brings cheaper premium and hence lower trading capital
2) theoretically limited risk but unlimited reward. (Higher risk-reward is possible) only if timed the direction correctly.
3) Near to Expiries If any Gamma effect plays a major role in bringing a higher risk-reward ratio
4) Can be used as an effective hedge for Equity / Futures trading / Option Seller’s Position and also to get margin benefit from the exchange.
The Negative side of OTM options
1)Lower Probability of Profit (Probability of Winning) typically less than 25% depending on the selected OTM strike. And deeper OTM strikes will have a Probability of Profits less than 15%.
2)Faster Time Decay
3)Reduced Implied volatility drastically reduces the premium of OTM options. Generally, near the event or post, the event Volatility collapse is very common that mostly brings destruction in the option premium.
When to Trade OTM Options?
From the above information, one can fairly guess that OTM Options trading can be applied only in a seasonal fashion. Statistically frequent trading in OTM options mostly brings damage to the portfolio due to the lower probability of winning.
However, If anyone still wants to pursue trading OTM Options then it is highly recommended to keep the holding period of the positions very shorter (pure Intraday) and avoid carrying forwarding of the positions, trading OTM options near the event or during the volatility crush period.
OTM Options are likely to perform well when there is a period of crisis, raising fear/greed, high or extreme high volatile conditions. In a regular trading market where the news flow or emotions are muted then largely OTM options holds very lesser odds to turn profitable.
Trading OTM Options on Expiry Day?
1)Zero to Hero Trades
2)Lottery Ticket Trades
Betting on such kinds of themes leads more toward intuition-based trades (gambling) rather than data-driven trading decisions. If one is an Option Buyer then expiry day option buying needs to be avoided unless the trade setup/market volatility/trading odd demands.
Even trading ATM Options buying and holding till expiry are not profitable on expiry unless the trades are managed with a very shorter holding period anywhere between 5-15mins on expiry. This is one of the reasons most of the option sellers flock on expiry day to capitalize on the exponential premium decay. For the option sellers, it is a faster profit in terms of time.
Statistical odds are very poor for the OTM buyers on expiry day unless the trader controls the holding period.
Trading OTM Options during the Last Hour of Trading on Expiry Day?
Last hour of trading if near OTM options need to be profitable one need to get a dramatic rise/fall in the underlying stock/index. Even if such a dramatic fall/rise happens in the weekly expiry mostly the price will be adjusted to the last 30mins of VWAP adjustment and options premiums are intelligent enough to adjust to the VWAP-based settlement ahead of expiry closing.
The Extreme Profitability of OTM Options during the last hour of Trading is less than 3%
In the case of stock options, if the OTM options buying resulted in ITM at the time of expiry then the stock options go for delivery-based physical settlement. STT on exercised contracts will be charged at the rate of 0.125% of intrinsic value which will be huge and unnecessary.
Conclusion
In a nutshell, trading OTM options is not really bad. Abusing OTM options by holding it for a longer period is really a bad one. To improve the odds of winning and to reduce the trading risk involved one has to adapt trading strategies with very short-term trading duration. OTM options are better suited for scalping/intraday trading and very rarely seasonal for positional and expiry day trades.
