A deep out of the money option contract is a financial instrument traders use to wager that the price of a security will be far different from the current price at some point in the future. Trading strategies built on deep out of the money options are enticing to traders as they allow for attractive asymmetric payoffs.
What are Deep Out of the Money Options (OTM)?
Deep out of the money options are one of the most interesting financial instruments available to traders. However, a full understanding of this security is needed to successfully use it in trading.
What is an OTM option? There are two basic types: calls and puts. An OTM call option is a call option whose strike price sits far above the current price of the underlying security, and an OTM put option is a put option whose strike price sits below.
In order for a call or put to be considered OTM, the delta of the instrument must exhibit an absolute value that equals no more than $0.5. The delta value of an option measures the sensitivity of the options contract, in dollars, to the change in price of the underlying security. Therefore checking the delta value is an easy way to determine whether or not an option is in fact OTM.
So, what exactly is a “deep OTM option”? This term refers to an option that is so far out of the money that its absolute delta value falls far below $0.50. What makes these sorts of options so compelling is that they can offer very favorable payoff profiles.
The reason that payoffs from deep OTM option strategies are so high can be attributed to the fact that options sellers believe there is a low probability the underlying will reach the strike price before expiration. The options are therefore priced cheaply to reflect this belief. Any appreciation of the underlying toward the strike price results in appreciation in the call option itself that is multiples greater.
Understanding The Trading Strategy
One of the more common ways to use OTM call options is buy them on “deep value” stocks. Because these securities trade at a discount to their inherent value, value-minded traders may expect them to trade up to a higher, more natural valuation over the long term. The strategy begins with the trader purchasing a deep OTM call option with a strike price at or below the sum of the fair-value price to which the stock is expected to trade plus any additional option premium.
A deep OTM call option typically features a delta of $0.1 to $0.2 and an expiration date that is roughly to a year from the current date. A one-year timeline gives the underlying security more time to reach its fair value price, or strike price, and therefore result in a profitable trade.
Identifying Deep Value Stocks
Deep value stocks are securities that currently trade at prices far below what a trader would consider to be fair value. Traders use different approaches to calculate fair value. Perhaps the most common technique of calculating fair value is to assume the market value of a stock is equal to the present value of all future cash flows of a company. Other methods of finding the fair value of a security include comparisons to historical valuations or comparisons to peers that share the same sector, theme or business model.
Finding deep value candidates to trade is often as simple as running a screen of stocks that have recently declined. Once a basket of stocks has been identified, a trader can discover the fair value of the securities by applying any of the methods described above.
Let’s see this strategy in action with an example that features call options on Netflix, Inc. (NFLX). At the time this article was written, NFLX stock was trading at a price 40% below its 52-week high of $700.
A natural question for any investor would be whether or not the stock would likely return to its 52-week high of $700 over the course of the next year. To answer this question, a value-oriented trader would likely perform an analysis to assess the fair value of NFLX, such as a discounted cash flow valuation, in order to confirm whether the stock might return to its 52-week high.
For the sake of the example, let’s assume that the discounted cash flow analysis produces a fair value for NFLX of around $700 per share. (Yes, we’re conveniently picking a number that equals the prior 52-week high.) The trader would then need to pick a call option trade now that a price target of $700 has been established.
Choosing the Option Contract to Trade
The next step for our trader is to select the right contract for implementing the strategy. Typically that means a call option with a delta value between $0.1 to $0.2. Ideally the strike price sits at or below the sum of what the trader believes to be the fair value of the stock and the premium paid for the option contract.
It’s also best to pick an option contract with expiration date about a year out in the future from the current date. This creates a reasonable amount of time for the underlying security to trade at or above the fair value, or strike price.
If a trader prefers a higher probability of the stock trading at or above the strike price, he might choose a later date. This allows for more time for the deep OTM payoff to materialize. The tradeoff is that the longer-dated option will cost more in terms of option premium due to the greater extrinsic value associated with more theta.
In our example of NFLX deep OTM calls, the trader would be looking to purchase a 1-year expiry call option with a delta value between $0.10 and $0.20 and a strike price at or below a value equal to the sum of the premium and the $700 price target.
As one can see from the NFLX option chain below, the 0.10 delta call has a strike price of $640, expires on March 17, 2023, and costs the trader $5.41.
The sum of the option premium and strike price totals $645.41. This value exceeds $50 but sits below the $700 price target. Here, the option contract provides the trader with a benefit due to its deep value, showing the usefulness of the deep OTM call option strategy.
Understanding the Payoff of the Strategy
A deep OTM strategy is attractive to many traders due to its potential for an outsized payoff. Since the strategy is built around a call option whose strike price sits far above the current price of the underlying, traders price this option lower than options that share the same expiry but whose strike prices are nearer to the price of the underlying.
Traders favor buying these strikes because the options are less risky: They are more likely to expire in the money compared to options with strike prices further away from the current price.
Assuming a trader holds a deep OTM call option until expiration, the final value of the position will equal the price of the underlying security in excess of the strike price. The option value has no extrinsic value since its value is settled at the time of expiration. Therefore, its intrinsic value is equal to the price of the underlying in excess of the strike price.
In the case of NFLX, the trader is risking a maximum of $5.41 in call option premium on a trade that could net a much greater amount. Let’s assume NFLX reaches the previously identified $700 price target at the time of expiration. In this situation, the trader would realize a profit of $54.59 on an original investment of $5.41– a return of 900%. If the stock failed to reach a price greater or equal to the sum of the call option premium and strike price, the trader would only lose the initial $5.41 in call option premium.
OOM vs. OTM
Some traders and brokerages will use the acronyms OOM and OTM interchangeably to describe an out of the money option. Traders must understand that OOM and OTM describe the same thing: An option that is out of the money (or has no intrinsic value) and an absolute delta value below 0.5.
Conclusion
A deep OTM option contract is a financial instrument that traders can use to wager that a security’s price will be far different from its current price at some point in the future. A deep OTM call option strategy used on deep value stocks allows traders to pursue a strategy with a favorable asymmetric payoff. In this case, the call option premium, which is small for deep OTM options, incentivizes traders to accept risk in the hope of making material profit after a successful trade.
As an experienced financial professional with a deep understanding of options trading, let's delve into the intricacies of the concepts discussed in the article about deep out of the money (OTM) options and the associated trading strategy.
Deep Out of the Money (OTM) Options: Deep OTM options are financial instruments that traders use to speculate that the price of a security will deviate significantly from its current price in the future. These options have strike prices that are far above (for call options) or far below (for put options) the current market price. The article emphasizes the importance of delta in determining whether an option is OTM. For an option to be considered OTM, its delta must exhibit an absolute value of no more than $0.5.
Trading Strategy: The trading strategy revolves around the asymmetric payoffs offered by deep OTM options. Sellers price these options cheaply because they believe there's a low probability that the underlying asset will reach the extreme strike price before expiration. The article then provides an example of using deep OTM call options on "deep value" stocks.
Identifying Deep Value Stocks: Deep value stocks are those trading significantly below what traders consider fair value. Various methods, such as discounted cash flow analysis or historical valuations, can be employed to identify fair value. The article suggests that after identifying a basket of deep value stocks, a trader can use deep OTM call options to capitalize on potential future appreciation.
Choosing the Option Contract: The article recommends selecting call options with a delta value between $0.1 to $0.2 and an expiration date approximately a year from the current date. The chosen strike price should be at or below the sum of the fair value of the stock and the option premium paid. This strategy allows for a reasonable timeframe for the underlying security to reach its fair value, maximizing the potential for a profitable trade.
Understanding the Payoff: The attractiveness of the deep OTM strategy lies in its potential for outsized payoffs. Deep OTM call options, with strike prices significantly above the current market price, are priced lower than options with closer strike prices. If held until expiration, the final value of the deep OTM call option equals the price of the underlying security in excess of the strike price. The payoff can be substantial, as illustrated in the example using Netflix (NFLX).
OOM vs. OTM: The article clarifies that some traders and brokerages may use the acronyms OOM (Out of the Money) and OTM interchangeably. Both terms describe an option with no intrinsic value and an absolute delta value below 0.5.
Conclusion: In conclusion, a deep OTM option contract is a powerful tool for traders seeking significant price movements in a security. The strategy discussed in the article, particularly using deep OTM call options on deep value stocks, offers an attractive risk-reward profile. By understanding the principles of option pricing, delta, and the dynamics of deep value investing, traders can potentially capitalize on favorable market opportunities.
