Cheap Out of the Money Options

Cheap out of the money options carry a high amount of risk. Yet being cheap, these options also have a high potential for reward. In order for these options to become profitable, the underlying market must make a big move in a short time. Otherwise, your options portfolio will spend its time breaking even and making meager profits while the options are nearing expiration. That's why it is almost always advisable to buy options with at least six months time until expiration in order to give the market a chance to make its move.

Speculative Calls

The most common use of out of the money options is with speculative calls. A call option is used for expected bull market rallies. In the case of buying cheap out of the money call options, the speculator can obtain more positions for the same amount of capital compared to buying call options that are nearer the market or "in the money."

For the stock market, a cheap call would be considered less than $2.00 per option. This equates to $200.00 per position or less. In the commodities futures market, it varies, but options are always more expensive than stock options. That's why investors who are transitioning from the stock market into commodities usually employ a speculative position by buying cheap out of the money calls so they can leverage more than just one position.

Calls vs Puts

From a holistic market viewpoint, out of the money puts are more richly priced than out of the money calls. This is a well-known fact, especially for the broader market indices, such as the S&P 500. The reasons for this are a pervasive risk aversion and an error of estimation in modeling the movement of prices during times of collapse and chaos. Knowing this simple fact allows an options trader a venue for advanced strategies. If you ever plan on writing options, or in other words, selling options, consider selling out of the money puts. Note, selling options has the aim of collecting premium and may require a high margin.

Known as one of the better selling strategies, selling out of the money puts involves less risk and a high probability for success in keeping the premium. Puts are richly priced because the market acts as a herd and because large money managers protect their equity portfolios by buying put options on the S&P 500. There is always a disproportionate amount of open interest in out of the money put options on the S&P 500. Look for that options market to write short-term puts.

In the case of selling options, it is almost always advisable to sell options with no more than three months left until expiration. Although you don't have the potential to garner as much premium, the position is a lot more probable for being successful. What's more, because of time value decay, your options will lose value a lot more rapidly than if you are selling options with a longer window of time. That's what you want when selling put options.

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