3 reasons OTM Options outperform in low volatility

F&O Market

Shubham Agarwal

Volatility for most part of the year 2023 has been on a lower side. The moves have been more or less slow overall.

This comes with a big problem. More time spent in the buy position of the option more we tend to lose. As well know the premium of an option reduces in value with passing time. This means, we will incur loss if there is no movement in the stock or index option bought even if it does move.

Along with this problem there also comes a bright side of Low Volatility trades. All the options across strikes and across type (Call & Put) trade at a lower value. So, the investment to get into a Buy position in the Option is very low in low volatility environment.

Here we can find a solution in strike selection and get the most out of the presented low volatility and slower moves. Majority of these low volatility markets are characterized by overall slow pace due to combination of Big Move + Long Consolidation kind of market. Now, it is difficult to spot the Big Move but it is easy to escape the Consolidation’s big losses.

Before we go into the strike selection let us understand Strikes can be divided into 3 Kinds.

ATM (At the Money): The strike we select will be close to the current market price.

OTM (Out of the Money): Call strike we select will be higher than the current market price and Put Strikes lower than current market price.

ITM (In of the Money): Call strike we select will be lower than the current market price and Put Strikes higher than current market price.Let us now focus on the reasons of Outperformance from OTM Options

Reason #1: Lower Investment

While ATM is straightforward, we can see OTM strikes signify Options to Buy Higher (Call) or Sell Lower (Put). This makes them less attractive because if the stock / index expires at the current level, OTM Calls and Puts will be Zero.

Due to this, in already lower premium environment OTM options are even cheaper. This is one of the primary reasons why OTM options outperform, because the investment or the Entry itself is easier

Reason #2: Higher Returns on Investment

Now the moves are same for all the options but for a given favourable move ITM options will rise more in premium than ATM. Similarly, ATM will rise more in Premium than OTM. If we concentrate on the absolute gain in premium, it does make OTM options unattractive among the 3 types. However, when we compare the Returns on Investment (Premium Profit / Premium *100) OTM options shine.

Reason #3: Lower Absolute Loss

Lastly, remember OTM Options are very small in value so there is not much to lose. So, if we stick to one position in one stock or index we will not be losing as much either, so easy exit.

Ultimately, it is the capacity to create Higher Returns and Inexpensiveness on Entry and Exit that makes OTM Options the best way to trade in low Volatility.