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Asked a question 2 years ago

Why is Deep OTM Option considered risky?

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Hi Pradeep, the word 'risk' is quite relative in this context. I say so because it depends on whether you are a buyer or a seller of a deep OTM option.

If you are a buyer of an option, the risk is limited to the extent of premium paid. If you have bought a deep OTM option, then the risk per lot is quite small as deep OTM options tend to be cheap. For instance, the Nifty 15850CE expiring on 29-July is currently trading at 79, meaning the outlay per lot would be 3950. On the other hand, the Nifty 16500CE is currently trading at just 1.5, meaning the outlay per lot would be just 75. So see that even if the option were to expire worthless, you would lose only 75 per lot. Having said that, keep in mind that deep OTM options tend to be cheap for a reason. If held until expiration, the probability of such options expiring ITM tends to be very low. As at the time of writing, the probability of 16500CE moving ITM is just 0.3%. Also, deep OTM options tend to have a very low delta, meaning their responsiveness to changes in the underlying price is very low. So, unless there is an unexpected big move in the price of the underlying, chances are that the buyer will lose money buying such options. So, from this standpoint, the risk of losing capital tends to be quite high.

For a seller, the impact would be opposite. The premium received would be quite low, but the probability of retaining the premium if the position is held until expiration would be high. That said, while the probability of suffering a loss would be quite low, keep in mind that if an unexpected large move in the price of the underlying causes the option to move ITM, the losses can get huge, if risk is not managed well. Remember, when selling an option, the writer is exposed to unlimited risk.

Hedge and define the risk....