What are option Greeks, and how do you use them?

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[Options ABC] What Are Out Of The Money Options? A Case Study of PDD

Moo Options Explorer joined discussion · Feb 27 18:26

Hello everyone and welcome back to moomoo. I'm options explorer. In today's [Options ABC], we'll be taking a look at out-of-the-money (OTM) options.

Wordcount: 2000
Target Audience: Investors who are interested in OTM options trading.
Main Content: What are the advantages and disadvantages of OTM options? What should you do when trading OTM options?

OTM options should not be an unfamiliar topic for option investors. On the one hand, OTM options may be more likely to receive a bigger percentage gain with similar price swings in the underlying stocks. On the other hand, OTM options have lower costs compared with ITM options and ATM options as it has no intrinsic value. However, it also has its own limitations, such as a higher possibility of expiring worthless and a limited profit probability.

Then, could OTM options be a good pick?

To answer this, let's begin with what out-of-the-money options are.

Options are different from stocks in that their price consists of two parts: intrinsic value and extrinsic value.

Option Price (Premium) = Intrinsic Value + Extrinsic Value (Time Value)

Options are typically split into three types: in-the-money, at-the-money, and out-of-the-money. Out-of-the-money options refer to those that have no intrinsic value.

ABC story: Alice and OTM Options

Let's examine the following hypothetical scenario.

Alice is currently interested in Pinduoduo's stock. As of November 2023, Pinduoduo's market capitalization is worth $188.3 billion. With PDD's price rising, she is eager to participate in the market. But when she examines the options chain, she hit a snag: an ATM option of PDD expiring at month's end costs around $500 to $600. Thinking twice, Alice concludes that it's not pocket change. Upon further examination, she noticed that deep out-of-the-money options are much less expensive. An ATM call option with a $142 strike price costs $5.02*100=$502, while an OTM call option with a $149 strike price costs $2.85*100=$285; An ATM put option with a $143 strike price costs $4.40*100=$440, while an OTM put option with a $136 strike price costs $2.26*100=$226.

[Options ABC] What Are Out Of The Money Options? A Case Study of PDD

(Any app images provided are not current and any securities shown are for illustrative purposes only and is not a recommendation.)

In such a case, it seems that OTM options are more feasible for Alice if she is on a tight budget. However, it's important to understand that buying OTM call options has a lower probability of success and a higher possibility of loss.

Now that we've discussed Alice's story, let's focus on the pros and cons.

Pros of out-of-the-money options:

Cheaper premiums: deeper out-of-the-money means lower cost

The biggest advantage of out-of-the-money options is their lower price. Since an option's value = intrinsic value + time value, out-of-the-money options can cost way less than what you might pay for ATM or ITM options.

High leverage

Out-of-the-money options often offer higher leverage than in-the-money and at-the-money options. This is due to their lower premiums relative to the underlying asset's price, which often move in tandem with changes in the asset's price. The increased leverage allows you to trade with less cash and potentially increase your returns. It seems that out-of-the-money options might be a good stand-in if at-the-money options are too pricey. But hold up, they have risks too.

Cons of Out-of-the-money Options:

In options trading, there's a bunch of terms called Greeks that help traders figure out how risky and pricey their options are. Let’s break down what these mean for out-of-the-money options.

Note: Option Greeks are calculated using options pricing models and are theoretical estimates. Greek values are based on the assumption that all other factors remain constant.

Delta (Δ)

Delta shows how sensitive the option price is to the underlying asset's price changes. For out-of-the-money options, Delta's usually under 50%, meaning the option's value only ticks up a bit if the asset's price rises but might plummet if the price drops. So, if you buy an out-of-the-money call option and the asset's price doesn't hit your strike price, you might lose your initial investment.

Gamma (Γ)

Gamma measures Delta's sensitivity to the asset's price changes. Out-of-the-money options often have higher Gamma than others, meaning their price is more volatile.

Vega (ν)

Vega is a measure of an option's sensitivity to changes in market volatility. Out-of-the-money options typically have lower Vega values, which means they're less responsive to market fluctuations. However, if market volatility significantly affects the option's time value, its price could plummet.

Theta (θ)

Theta measures the rate at which an option's price decreases over time. Out-of-the-money options typically have higher Theta values, meaning they lose their time value more quickly. As expiration approaches and the asset's price fails to reach the strike price, investors who purchase these options risk losing their initial investment. Additionally, it is important to note that the likelihood of exercising deep out-of-the-money options is extremely low. Even if the option reaches the strike price as expected, investors may still incur losses if the price fails to reach the break-even point.

Out-of-the-money options are a nifty tool in trading. They're relatively cheap, offer great leverage, and can be used for hedging. However, they also come with some drawbacks. These options tend to lose value more easily and require careful handling. Additionally, the price of out-of-the-money options can be more difficult to predict, so investors need to thoroughly research and be cautious when using them. There's a greater likelihood that OTM options expire worthless which means losses would occur.

That's all for today! Please feel free to leave a comment if you have any questions or thoughts.

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Options trading is very risky and is not appropriate for all customers. Read the Characteristics and Risks of Standardized Options (j.us.moomoo.com/00xBBz) before considering trading options. Options transactions are complex and may involve losing the entire investment in a short period of time. Supporting documentation for any claims, if applicable, will be furnished upon request.

Risk Statement

The examples provided herein are for illustrative and educational purposes only and not intended to be reflective of results any investor can expect to achieve. The figures shown in the examples are not guarantees or projections, and no taxes or fees/expenses are included in the calculations which would reduce the figures shown. Actual results will vary.

Moomoo is a financial information and trading app offered by Moomoo Technologies Inc. In the U.S., investment products and services on Moomoo are offered by Moomoo Financial Inc., Member FINRA/SIPC.

This article is for educational use only and is not a recommendation of any particular investment strategy. Content is general in nature, strictly for educational purposes, and may not be appropriate for all investors. It is provided without respect to individual investors’ financial sophistication, financial situation, investment objectives, investing time horizon, or risk tolerance. You should consider the appropriateness of this information having regard to your relevant personal circumstances before making any investment decisions. All investing involves risks. Any examples are provided herein are for illustrative purposes only and not intended to be reflective of results any investor can expect to achieve.

Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount. Supporting documentation for any claims, if applicable, will be furnished upon request.

Moomoo does not guarantee favorable investment outcomes. The past performance of a security or financial product does not guarantee future results or returns. Customers should consider their investment objectives and risks carefully before investing in options. Because of the importance of tax considerations to all options transactions, the customer considering options should consult their tax advisor as to how taxes affect the outcome of each options strategy.

Disclaimer: Moomoo Technologies Inc. is providing this content for information and educational use only. Read more

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