When a football team is down in the closing seconds and the team has no alternatives but to heave up a desperation throw towards the end zone, it is often referred to as a “Hail Mary” pass. In other words, there is a slim chance that the play will work out. The funny thing about that is that option traders do the same all the time especially in earnings season when options have elevated premiums due to the pending announcement.
It seems like almost every other week and even more so during earnings that a student will ask me about buying deep out-of-the money (OTM) options. Many option traders, especially those that are new, initially buy deep out-of-the-money options because they are cheap and can offer a huge reward. Unfortunately, many times, these “cheap” options are rarely a bargain. Don’t get me wrong, at first glance an OTM call that costs $0.25 may seem like a steal. But if the call’s strike price is say $20 or $30 (depending on the stock price) above the market and the stock has never rallied that much before even over an earnings announcement in the amount of time until expiration, the option will likely expire worthless or close to it.
Many factors work against the success of a deep OTM call from profiting. The call’s delta (rate of change of an option relative to a change in the underlying) will typically be so small that even if the stock starts to rise, the call’s premium will not increase much. In addition, option traders will still have to overcome the bid-ask spread (the difference between the buy and sell price) which might be anywhere from $0.05 to $0.15 or even more for illiquid options.
Option traders that tend to buy the cheapest calls available are probably calls that have the shortest time left until expiration. If an OTM call option expires in less than thirty days, its time decay measured by theta (rate of change of an option given a unit change in time) will be often larger than the delta especially for higher priced and more volatile stocks. Any potential gains from the stock rising in price can be negated by the time decay. Plus each day the OTM call option premium will decrease if the stock drops, trades sideways or rallies just a tad.
A deep OTM call option can become profitable only if the stock unexpectedly jumps much higher. If the stock does rise sharply, an OTM call option can hit the proverbial homerun and post impressive gains. The question option traders need to ask themselves is how much are they willing to lose waiting for the stock to rise knowing that the odds are unlikely for it to happen in the first place? Trades like these have very low odds and may be better suited for the casino then the trading floor.
Senior Options Instructor