For an options trader, one of the most remarkable aspects of the 2008 financial crisis was that it featured months in which many options closed in or near the money when, even weeks before, they were deep out-of-the-money (DOTM) and “worthless.” The lesson is that ostensibly overpriced options are totally devoid of value, until they aren’t. This is not a new lesson: academics have spent decades creating and testing different models (Hull and White, Heston, Dupire, etc.) to better accommodate the existence and dynamics of volatility surfaces, and practitioners know just as well that a ten-cent put option will look like an easy sale up until the day that the market tanks. You don’t need to be a financial engineer to know that deep out of the money options can be deceptively tricky to price.
This isn’t dogma. If a trader is willing to sell short-term puts for a few pennies every month with the full knowledge that someday, those puts aren’t going to expire worthless, and that such unpleasant outcomes will occur more frequently than a normal distribution would suggest, that trader isn’t necessarily vicious or stupid. The problem is that there are still many traders who are willing to make the sale without knowledge of those two conditions. In spite of the substantial literature on this topic, and in spite of the practical lessons of the numerous crises of the last few decades, I still field questions from traders seduced by the allure of deep out-of-the-money options.
One reader recently wrote in to ask why we trade such (relatively) narrow spreads, when “I see many other newsletters (with deep OTM strikes) thriving in this environment.” Now, if our performance in 2009 doesn’t constitute “thriving,” I don’t know what would. Moreover, those same DOTM option sellers generally blew up during the 2008 crisis, even as we dodged the crash by keeping our subscribers in cash. But more importantly, there’s a good theoretical reason why we trade narrower spreads instead of aiming for the “easy” DOTM approach: dynamic delta hedging becomes significantly more difficult the further out of the money you go.
Given the nature of gamma, this point is practically tautologous. If I sell two at-the-money (ATM) Emini S&P 500 puts today, my total delta exposure will be about 50. I can offset that directional risk by selling 50 deltas of the underlying – in this case, one futures contract. And I’ll know that, if the underlying declines dramatically over the next several days or weeks, the options I’m short only have another 50 deltas remaining before they are functionally long futures positions, meaning that I’ll only potentially need to sell one additional futures contract to totally hedge the directional risk in the options. (In practice, dynamic delta hedging is a messy and non-trivial activity, but it sure beats not managing risk at all.)
Contrast this with a DOTM approach. For starters, most DOTM options sellers will take on undesirable amounts of risk. The two ES February 1125 puts used in my example above would bring in a premium of about $3150; to bring in the same amount, a trader selling 10 delta options (the ES February 1000 puts) would have to sell about 12 contracts. At the start of the trade, their directional exposure will be similar – roughly 68 deltas – and the same step of shorting one futures contract would apply. But whereas the increasing directional risk in our ATM trade maxes out at 100 deltas with the S&P 500 at 990, the DOTM options make you progressively longer the underlying, maxing out at 600 deltas with the S&P near 830. In other words, the DOTM options seller must be prepared to hedge six times as much directional risk for the same potential reward. Some novice traders destroy their accounts, AIG-style, by risking so much on options positions that they aren’t sufficiently capitalized to offset those risks when things get dicey.
The DOTM advocate has two responses to this critique. First, they can insist on reasonable risk levels, selling far fewer options than in the example given above. In my experience, this rarely happens: as a percentage of the capital employed, the returns from the saner version of a DOTM approach are so small they aren’t likely to attract the unsophisticated retail traders who usually flock to the strategy. Second, the options seller might note that further out of the money options are unlikely to be threatened except by the most violent market swings; most swans, they will remind us, are white. But this is no response at all: my contention is that if we grant the claim that DOTM and ATM approaches to option selling will offer similar returns over the long run, the crucial advantage borne by the latter is that it alone permits straightforward risk management.
Photo: Andy Warhol and Edie Sedgwick, subject of The Velvet Underground‘s “Femme Fatale.”