Deep out of the money option trading

Option trading has seen a tremendous growth in recent times. Basically there are two types of options Call and Put. Call options give the buyer a right to buy a security at a particular price on or before a particular date. Put options on the other hand give the option buyer, the right to sell a security at a particular price on or before a particular price. Please remember that the buyer doesn't have an obligation to exercise where as an option seller has an option obligation in case a buyer chooses to exercise his option. To compensate for the risk a seller takes, he charges the buyer a fee, known as premium. An option seller faces unlimited downside where as the maximum downside of an option buyer is the premium he has paid. Due to the favorable risk-reward ratio for a buyer, options have proved to invaluable tools for an informed investor.

An option is said to be out of the money when it doesn't make an economic sense to exercise an option. Even an At the money option may not make an economic sense. For instance if a call option is bought for a strike price of $100 and the current market price is $90, the option if exercised will result in a loss to the buyer. Hence it is said to be out of the money when market price is $90. The same option will be in the money if the market price moves above $100. In this case, the buyer can exercise the option, buy the security from the seller at $100 and sell it at the market price. This results in some profit to the buyer if premiums are ignored. Hence an option is said to be in the money if it makes sense to exercise the option.

An out of the money option is a great way to benefit from extreme movements in the market. A deep out of the money option such as a Put option on S&P 500 at strike of 1000 can be a great way to execute a bearish strategy. This would be beneficial only if S&P 500 goes below 1000. If the option is long dated, (3 months or more), it makes it all the more desirable. More importantly, deep out of the money options can offer tail protection to a portfolio. The rare events if occur provide asymmetric pay-offs. One possible rare event could be the Greek default. The best way to benefit from such an event is to keep buying Deep out of the money European Equity Index options. Some possible indices could be Dax (German), CAC (French) or Eurostoxx50.