Benefits of Trading Out-of-the-Money (OTM) Options

Are you a trader who's looking to increase your profits while minimizing your risk? If so, you might want to consider trading out-of-the-money (OTM) options. We'll explore the benefits of trading OTM options, how they work, and why they can be a powerful tool in a trader's arsenal.

Here's what you can expect to learn:

1. The difference between intrinsic value and extrinsic value and how it relates to ITM and OTM options
2. The primary objective of trading OTM options and how to take advantage of their leverage with a fixed amount of risk
3. The 3 ways to manage an options position, including gamma scalping, and why it's our favorite method at Masters in Traders.

By the end of this article, you'll have a better understanding of OTM options and the benefits of trading them. You'll also learn about position management techniques like gamma scalping that can help you maximize your profits while minimizing your risk. And if you want to take your trading to the next level, we'll show you how to get our four best long OTM option trades every week by joining the Masters in Trading Community.

Intrinsic Value and Extrinsic Value

Intrinsic, positive intrinsic value, and extrinsic value are two important concepts that you need to understand when trading options. Intrinsic value is the value that an option has if it were exercised immediately. In other words, it's the amount of profit that an option would yield if it were exercised right now. Extrinsic value, on the other hand, is the value that an option has above its intrinsic value. This is also known as time value, as it's the value that's derived from the amount of time left until the option's expiration date.

Now, let's talk about absolute value and how these concepts relate to in-the-money (ITM) and out-of-the-money (OTM) options. ITM options have intrinsic value, as they have already reached the strike price and are worth exercising immediately. This means that the option's intrinsic value is the difference between the current market price of the underlying asset and the option's strike price. For example, if you have a call option with a strike price of $50 and the current market price of the underlying asset is $60, the option has an intrinsic value of $10.

On the other hand, OTM options do not have intrinsic value, as they have not yet reached the strike price. However, they do have extrinsic value, which can be broken down into two components: time value and volatility value. Time value is the value that's derived from the amount of time left until the option's expiration date, while volatility value is the value that's derived from the potential for the underlying asset to move in particular price again.

How Volatility Impacts Out of the Money (OTM) Options

Options trading can be a bit complicated, but understanding the different factors that affect option prices can help you become a better trader. In particular, OTM (out of the money) options are very sensitive to changes in volatility, and this is because of a few key factors.

Volatility is the measure of how much the price of an underlying asset is expected to fluctuate over a certain period of time. When volatility is high, the price of the underlying asset can move a lot, which can be good for options traders.

Vega is the Greek letter used to represent an option's sensitivity to changes in volatility. OTM options have a higher vega than ITM (in the money) options, which means that they are more sensitive to changes in volatility.

Theta is another Greek letter used to represent the time decay of an option. As an option gets closer to its expiration date, it loses value because there is less time for the underlying asset to move in the desired direction. OTM options have a higher theta than ITM options, which means that they lose value faster as they get closer to expiration.

Gamma is the Greek letter used to represent an option's sensitivity to changes in the price of the underlying asset. OTM options have a higher gamma than ITM options, which means that they are more sensitive to changes in the price of the underlying asset.

So, how do all of these factors affect the pricing of OTM options vs ITM options? When volatility is high, the price of both OTM and ITM options will generally increase. However, because OTM options have a higher vega than ITM options, they will generally increase in price more than ITM options. This means that OTM options can be a good choice for traders who are looking to take advantage of changes in volatility.

When it comes to theta, OTM options will generally lose value faster than ITM options as they get closer to expiration. This means that traders who are looking to hold options for a longer period of time may prefer ITM options over OTM options.

Finally, gamma is a bit more complicated. When the price of the underlying asset moves, both OTM and ITM options will increase in price (if the price moves up) or decrease in price (if the price moves down). However, because OTM options have a higher gamma than ITM options, they will generally increase or decrease in price more than ITM options.

This means that traders who are looking to take advantage of short-term price movements may prefer OTM options over ITM options.

Here are five key takeaways to remember:

1. OTM options are more sensitive to changes in volatility than ITM options.
2. OTM options have a higher theta than ITM options, which means they lose value faster as they get closer to expiration.
3. OTM options have a higher gamma than ITM options, which means they are more sensitive to short-term price movements.
4. When volatility is high, the price of both OTM and ITM options will generally increase, but OTM options will generally increase in price more than ITM options.
5. Traders who are looking to take advantage of changes in volatility or short-term price movements may prefer OTM options, while traders who are looking to hold options for a longer period of time may prefer ITM options.

What's the Objective of Trading OTM Options?

Speculators who are bullish on a stock might buy OTM call options, which gives them the right to buy the stock at a specific price (strike price) at a later date. If the stock price increases, the call option will become more valuable, with higher premium, and the speculator can sell the option for a profit. On the other hand, if the stock price doesn't increase, the speculator will lose the premium paid for the option.

Similarly, speculators who are bearish on a stock might buy OTM put options, which gives them the right to sell the stock at a specific price (strike price) at a later date. If the stock price decreases, the put option will become more valuable, and the speculator can sell the option for a profit. If the option expires worthless the stock price doesn't decrease, the speculator will lose the premium paid for the option.

Hedgers might buy OTM put options contracts as a way to protect their portfolio from a sudden market move. For example, if a trader holds a long position in a stock and is worried about a sudden market correction, they might buy an OTM put option to limit their potential losses if the stock price drops. In this case, the premium paid for the put option acts as an insurance premium, and the hedger can feel more secure in their position.

One of the advantages of buying OTM options is that they can be purchased for a fairly inexpensive price. This means that traders can gain exposure to a stock's market price with a limited amount of capital. Additionally, if the stock is volatile, OTM options can offer traders a lot of flexibility and options. If the stock price moves significantly in the desired direction, the trader can make a large profit with a relatively small investment.

How Can Traders Manage an OTM Options Position?

There are a few different ways that traders can manage an OTM options position. One strategy is to simply hold the position until expiration and hope that the trade goes in your favor. Another strategy is to sell the option before expiration, using money options, either to take profits or cut losses.

Another strategy is to use options spreads to limit your risk and increase your potential reward. For example, you could buy the current price of an OTM call option and sell a higher-strike call option in the same expiration cycle. This creates a bull call spread, which limits your potential losses while also limiting your potential profits.

Alternatively, you could use a bear put spread if you think a particular stock is going to decrease in price. This involves buying an OTM put option and selling a lower-strike put option in the same expiration cycle. This creates a bear put spread, which limits your potential losses while also limiting your potential profits.

The bull call spread and the bear put spread are essentially the same trade, just one is bearish and the other is bullish.

Gamma Scalping: The Key to Managing Time Decay and Maximizing Profits

Gamma scalping is a popular way to manage an options position and involves buying and selling options to maintain a neutral delta. Delta is the rate of change in the option price with respect to the underlying asset price. When traders buy or sell options, they take on delta risk. Gamma measures the rate of change in delta with respect to changes in the underlying asset price. Traders can use gamma scalping to minimize their delta risk and make back lost theta.

Gamma scalping is a continuous process of buying and selling options to maintain a neutral delta position. As the underlying asset price moves, the delta of the options changes. Traders can use this change in delta of stock prices to their advantage by buying or selling options to maintain a neutral delta position. This means that they are not exposed to any delta risk and can profit from small movements in the underlying asset price.

Gamma scalping is particularly useful when trading options that are affected by time decay. Time decay, also known as theta, is the amount of time value that comes out of an option's premium on each day. This means that options lose value as they get closer to expiration. To make back lost theta, traders must scalp gamma by buying and selling options to maintain a neutral delta position.

Here are five reasons why traders gamma scalp to make back lost theta:

1. To minimize delta risk: Gamma scalping helps traders maintain a neutral delta position and minimize their delta risk.
2. To profit from small movements in the underlying asset price: Gamma scalping allows traders to profit from small movements in the underlying asset price.
3. To make back lost theta: Theta is the time that comes out of an option, and gamma scalping is a way to make back lost theta.
4. To hedge against sudden market moves: Gamma scalping can be used as a way to hedge against sudden market moves.
5. To generate income: Traders can use gamma scalping as a way to generate income from their options positions.

In conclusion, trading options can be an excellent way to maximize your profits while minimizing your risk. However, it's important to remember that selling options comes with unlimited risk, while buying options allows you to take advantage of optionality and get massive leverage with a fixed amount of risk. By learning about position management and gamma scalping, you can make back lost theta and further reduce your risk.

At Masters in Trading, we believe that trading options from the long side is the way to go. If you want to take your options trading to the next level and receive our 4 best long OTM option trades every week, we invite you to join Masters in Trading Community.

With our guidance and expertise, you'll be well on your way to achieving your trading goals. Don't wait, join us today and start trading smarter, not harder!