What it means
Deep out of the money options have no intrinsic value at all. Their entire price is time value, which is the market's estimate of the chance that the underlying moves far enough before expiry.
As expiry approaches, that estimate collapses towards zero. The attraction is the shape of the payoff.
Risking a small premium for a large potential gain suits anyone who wants protection against an extreme move, or who holds a strong view that the consensus does not share. The catch is that most such options expire worthless, so the strategy loses small amounts repeatedly.
Delta is very low, often below 0.10, so the option barely responds to ordinary price movements. What it does respond to is volatility: if the market suddenly expects bigger swings, the price of these contracts can multiply even without the underlying moving much.
That makes them a way of trading volatility rather than direction. Institutions buy them as tail risk insurance.
A pension fund might buy deep out of the money index puts so that a severe market fall is partly offset, accepting the annual cost as an insurance premium. Selling them is the opposite trade: steady small income punctuated by a rare, very large loss.
The risks of selling are widely underestimated. A seller collects a tiny premium in return for an enormous but unlikely obligation, and one bad event can wipe out years of accumulated income.
Anyone running that strategy needs collateral and position limits sized for the disaster, not for the average week.
In practice
Real-world examples.
Example
A pension fund buys deep out of the money index put options every year as protection against a market crash, spending about 0.5% of the portfolio value annually. In most years the options expire worthless and the cost is treated simply as insurance.
Example
A biotech analyst convinced that a trial will succeed buys $60 strike calls on a $22 share for $0.25 each. The trial fails, the shares fall further, and the whole $12,500 position is lost.
Example
A retail trader sells deep out of the money puts on an index for a small monthly premium and does well for eighteen months. A sudden 14% drop in one week triggers losses many times the total premium collected.
Formula
Calculation
Breakeven for a bought call = Strike price + Premium paid. Required move = (Breakeven / Current share price) - 1.
A share trades at $120. A call option with a $200 strike expiring in six months is quoted at $0.40 per share.
Breakeven = $200 + $0.40 = $200.40. Required move = ($200.40 / $120) - 1 = 1.67 - 1 = 0.67, which is a rise of 67% in six months just to break even.
One contract covering 100 shares costs $0.40 x 100 = $40. Buying 50 contracts costs $2,000 and controls 5,000 shares, which would be worth $50,000 if the share reached $210 by expiry, but returns nothing at all if it stays below $200.Case study
Seen in the real world.
Ashcombe Partners is an illustrative hedge fund created for this entry and does not exist. It ran a strategy of selling deep out of the money index put options, collecting around $180,000 of premium a month against a $60,000,000 portfolio.
For twenty-six months the trade worked, adding roughly $4,680,000 of premium income and a very smooth-looking return line. The founders described the risk as remote, because the strikes sat 25% below the index level.
Then the index fell 31% in five weeks. Positions that had never mattered suddenly mattered enormously, and the fund lost about $9,400,000, roughly double everything it had collected. The numbers here are fictional, but the shape of the outcome is a well-known hazard of selling far out of the money options.
Watch out
Common mistakes.
- Buying them because they look cheap, when the low price mostly reflects a low probability of ever paying out.
- Selling them for steady income without sizing the position for a rare extreme move.
- Assuming the option needs only a small rise to profit, when the required move includes the whole gap to the strike plus the premium.
Questions
People also ask.
Why are deep out of the money options so cheap?
Because they have no intrinsic value and the chance of finishing in the money is low, so the premium is almost entirely a small amount of time value.
Can they still be profitable?
Yes, occasionally spectacularly, but the strategy relies on rare large payoffs covering a long run of total losses.
Do they lose value faster near expiry?
Yes, time decay accelerates and a deep out of the money option can fall from a small price to nothing within days.
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