Mastering Derivatives: Trading deep OTM puts

Some individuals prefer to buy out of money (OTM) deep Nifty devices. Their goal is to buy at absolute low prices with the hope of making a handsome profit if the market drops significantly. This week we discuss whether buying deep OTM Nifty devices is optimal.

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Think of a deep OTM position as one that has a low probability of expiring in the money (ITM). If we interpret loosely Delta to mean the probability that the option will expire ITM, we can define a deep OTM mode as one that has a delta of about -0.10. This means that the option only has a 10 percent chance of the ITM expiring. The delta of the sell position contains a minus sign to indicate that the position is moving in the opposite direction of the primary trend. With Nifty at 17783, 17400 next week OTM is deep with delta -0.11.

If you were to buy the May 17400 put in the index, the probability of the option ending ITM is higher. That is, the longer the life of the option, the higher the chances of the option ending ITM. For example, the May 17400 put has a delta of -0.22, which is twice as likely to end ITM as the same strike next week. Therefore, an option can be considered deep OTM based on two factors – how far away the strike is from the current underlying price and the option’s expiry time.

The question is: Is it better to buy deep OTM Nifty devices? The argument is relevant because such positions can generate nice profits if the Nifty Index crashes. Consider the May 17000 Nifty position which has a delta of -0.10. The index could fall more than 783 points by May 25 from May 17,000 to become the ITM. But what if the event never happened and 17,000 ended up worthless? What if you are buying deep OTM and constantly betting to lose money frequently? To reduce the possibility of repeated losses, look for possible bullish exhaustion after a sustained uptrend. One of these indicators could be four or more consecutive green candles on the weekly Nifty chart. Note that the chances of the trade failing to make a profit are still high due to option oversold (deep OTM).

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OTM Nifty deep position will result in big gains when the market crashes, which is a rare event. This means that you can experience a series of losses before you make a gain. It makes no sense for a trader to follow a strategy of accumulating losses for months on end in the hope of making gains later. Note that for market monitoring purposes, the NSE defines a deep OTM option as a strike that is 30 percent away from the current underlying price. While strikes to date on stock options may be available, even though they are illiquid, they may not be available on the Nifty index.

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