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Buying Options: Beware of Deep Out-of-the-Money Options
by Rick Thachuk
Many option traders, especially beginners, are drawn into buying deep out-of-the-money options. In this article, I’ll explore this strategy and show that, despite its apparent advantages, it is unlikely to build wealth in the long run.
A call option is said to be out-of-the-money if the strike price is above the market price of the underlying futures contract. A put option is said to be out-of-the-money if the strike price is below the market price of the underlying futures contract. In both cases, the further away is the strike price, the deeper the option is out-of-the-money. Recall that in order for an option to have value upon expiration, the futures price must be above the strike price in the case of a call option, or below the strike price in the case of a put option. The more deep out-of-the-money is the option, the farther the futures price must move by option expiration. The larger the needed movement, the less likely it will occur and so, the more likely it is that the option will expire worthless.
Deep out-of-the-money options have a low cost and so, the percentage payoff can be tremendous if, and that’s the important word, the underlying futures contract moves beyond the option’s strike price by the time the option expires. For instance, with September cocoa futures at 850, the 1100 strike call option costs only $180. However, cocoa futures must rise to over 1100 by the time the option expires on August 5 for the call option to expire with value, and beyond 1118 to generate profit.
Unfortunately, in a large proportion of cases, the underlying futures fails to move sufficiently and the deep out-of-the-money option expires worthless. The premium paid, although relatively small, is lost. This fact is so well recognized that the Commodity Futures Trading Commission, the federal regulator of the U.S. commodity markets, requires in the Options Disclosure Statement given to every potential options customer the following disclosure; “Customers who are contemplating the purchase of deep out-of-the-money options should be aware that the chance of such options becoming profitable ordinarily is remote”. Furthermore, the National Futures Association which regulates marketing and communication with the public requires that brokers “monitor adequately the solicitation and sale of deep out-of-the-money options“.
Having worked as a broker specializing in serving the beginning trader, I am aware of the tendency of customers to want to buy as many deep out-of-the-money options in as many markets as is possible in the hope that at least one of them will payoff significantly. They view these options much like lottery tickets. I have witnessed that such a strategy rarely pays off. Long run profitability of this strategy is hampered by the unlikelihood of a sufficient movement of the underlying futures price, as was discussed above, and the cost of the trade. The cost of the trade consists of the option premium and transaction fees. In many cases, premiums of deep out-of-the-money options trade at a higher value than what is theoretically expected. Furthermore, even though the cost of the option premium can be low, the option buyer must still pay commission and other transaction fees and these can be significant compared to the option premium. For instance, commission and fees may be 25% to 50% of the premium of an out-of-the-money option.
I, instead, advise customers to balance their investment portfolio with other strategies that have a higher likelihood of becoming profitable. While there is certainly nothing wrong with buying deep out-of-the-money options on occasion and during those times when a large futures price movement seems imminent, the beginner should not allocate all of their trading capital to this strategy.
Rick Thachuk is President and Co-Founder of World Link Futures, Inc., a registered educational Commodity Trading Advisor serving the beginning futures, options and FOREX trader. http://www.worldlinkfutures.com
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