Deep Out Of The Money

A deep out of the money (deep OTM) option is one whose strike price is far from the current market price of the underlying asset, making it unlikely to have any intrinsic value at expiration. A call option is deep out of the money when the underlying stock trades significantly below the strike price. A put option is deep out of the money when the underlying trades significantly above the strike price. These options carry very low premiums because the probability of them ever becoming profitable before expiration is small.

They are the lottery tickets of the options market: cheap to buy, rarely profitable, and occasionally transformative for the buyer when conditions turn dramatically in their favor.

How Deep OTM Options Are Priced

Options pricing uses delta as a measure of how sensitive the option's price is to a $1 move in the underlying asset. At-the-money options have deltas around 0.50. Deep out of the money options have deltas close to zero, sometimes 0.05 or lower. This reflects the market's assessment that the option has very little chance of expiring with value.

Deep OTM options are composed almost entirely of time value and implied volatility, with no intrinsic value at all. If a stock trades at $50 and you hold a call with a $90 strike expiring in 30 days, the only reason that option has any price is the theoretical possibility that the stock could somehow reach $90 before expiration. As expiration approaches and the stock stays at $50, that option approaches zero through theta decay.

Why Traders Use Deep OTM Options

Deep OTM options serve several specific purposes depending on the trader's strategy.

• Low-cost directional speculation: A trader who believes a stock will move dramatically in one direction can buy deep OTM options for a fraction of the cost of at-the-money options. The risk is the entire premium paid. The potential payoff, if the underlying makes a large move, can be many multiples of the investment.
• Tail risk hedging: Portfolio managers buy deep OTM puts as insurance against catastrophic market declines. The premium is small relative to the portfolio size, but the puts deliver significant protection if the market falls sharply.
• Selling premium income: Some traders sell deep OTM options to collect the small premium. They expect the option to expire worthless and keep the entire premium as income. The risk is that an unexpected large move in the underlying puts them deeply in the money on the short side.

The Volatility Relationship

Deep OTM options are highly sensitive to changes in implied volatility. A sharp spike in implied volatility, even without any move in the underlying asset, can cause the value of a deep OTM option to increase significantly. This is why deep OTM puts on major equity indices often increase in price when market fear rises, even before any actual decline occurs.

Traders who buy deep OTM options are sometimes described as long volatility or long vega. A 10% increase in implied volatility can double the value of a deep OTM option even if the underlying has not moved at all.

Deep OTM Options as Tail Risk Insurance

Nassim Taleb's work on tail risk popularized the strategy of systematically buying deep OTM options as insurance against rare, high-impact events. The strategy accepts small, consistent losses from premium decay in exchange for catastrophic-event protection. It is most compelling for institutional portfolios where a 30% to 50% drawdown would trigger forced selling, regulatory action, or investor redemptions.

Sources

• https://www.cboe.com/education/
• https://www.sec.gov/investor/alerts/ib_options.pdf