Buying Options Part III: Beware of Deep Out-Of-The-Money Options

March 31, 2009 07:00 PM

Rick has been involved in various aspects of the futures and options markets, including positions as an economist and derivatives market analyst at the Bank of Canada and Finex. In 1996, he founded World Link Futures Inc. to serve the beginning futures trader.

In our last few columns, we've described various issues associated with buying options, such as reading option prices and how to select a strike price. In this column, we look at another potential problem area for beginning traders, namely, deep out-of-the-money options.

A call option is out-of-the-money if the strike price is above the market price of the underlying futures contract. A put option is out-of-the-money if the strike price is below the market price of the underlying futures contract. In both cases, the further away the strike price is from the market price, the deeper the option is out-of-the-money. 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 deeper out-of-the-money the option is, the more the futures price must move by the option's expiration. The larger the needed movement, the less likely it will occur and the more likely the option will expire worthless.

Deep out-of-the-money options have a low cost and 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 Aug. 5 expiration for the call option to expire with value, and beyond 1118 to generate profit.

Unfortunately, in most 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 is so widely 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 adequately monitor the solicitation and sale of deep out-of-the-money options.

As a broker specializing in serving the beginning trader, we are aware of the tendency of customers who want to buy as many deep out-of-the-money options in as many markets as possible in the hope that at least one of them will payoff significantly. They view these options much like lottery tickets. We have witnessed that such a strategy rarely pays off. The unlikely movement of the underlying futures price, as was discussed above and the cost of the trade hampers the long run profitability of this strategy. 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 are at a higher value than what theoretically is expected. Furthermore, even though the cost of the option premium can be low, the option buyer must pay commissions and other transaction fees and these can be significant compared to the option premium. For instance, commissions and fees may be 25% to 50% of the premium of an out-of-the-money option.

Therefore, customers need 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 his trading capital to this strategy.

About the Author
Rick Thachuk is president of WLF Futures, Options & Forex Education Network. Contact him via www.worldlinkfutures.com