The importance of instrinsic value and time value of options …
Buying out-of-the-money (OTM) options can be a tempting strategy because they are cheaper than at-the-money or in-the-money options. However, there are several reasons why buying OTM options is not always the correct way to trade options:
- Lower Probability of Profit: OTM options have a lower probability of expiring in the money, which means that the option buyer has a lower probability of making a profit. In fact, the probability of an OTM option expiring in the money can be as low as 10% or even less.
- Time Decay: All options lose value over time due to time decay, but OTM options are especially vulnerable to this. As the expiration date approaches, the value of an OTM option can decrease rapidly, even if the underlying stock price remains unchanged.
- Higher Volatility: OTM options are typically more volatile than at-the-money or in-the-money options, which means that they can experience larger price swings. This can lead to bigger losses for option buyers.
- Limited Upside: Even if the underlying stock price does move in the direction of the option buyer’s prediction, the potential profit from an OTM option is limited. The farther out of the money the option is, the smaller the potential profit.
- Spreads and Liquidity: OTM options may have wider bid-ask spreads and lower liquidity, which can make it more difficult to enter and exit positions at desired prices.
All in all, buying OTM options can be a high-risk, high-reward strategy that is suitable for experienced traders who are willing to accept the risks involved. However, for most traders, it is usually more prudent to buy at-the-money or in-the-money options, or to use other option strategies that provide a higher probability of profit and lower risk.