How “Out” is Out of the Money? Options for Fear and Volatility

Editor’s note: This is part one of a two-part series on out-of-the-money options.

During extreme market conditions, put and call strikes for some stocks, commodities, and indices can trade at eye-opening levels—prices that seem highly unlikely, to put it mildly. This suggests that some of the “smart” money sees a chance (however small) of the market actually reaching these levels—or at least coming close.

So how does the smart money find opportunity amid volatility? And should you take an interest in their insight?

When markets hit extremes, traders tend to shy away from volatile instruments like options. Implied volatility can spike and hit excessive levels very quickly, and that scares people, particularly when the prices are trading wildly to the downside.

But for contrarian traders, that’s just when they say opportunity comes a-knocking.

The CBOE Volatility Index ($VIX), appropriately dubbed the “fear gauge,” measures the expected (or implied) volatility in the S&P 500 for the next 30 days. It rises when traders start to worry about the markets. When the VIX reaches relatively high levels, the temporary spike impacts traders psychologically, and their confidence for new bullish trades can evaporate.

Contrarian traders sense the blood-letting and pounce. And with options, their trade ideas can come relatively cheap. Let’s look at an example.

When volatility is low or falling, market makers may typically trade strike prices for a popular exchange-traded fund that tracks a major index (or the options on the actual index) that are $10 to $15 out of the money (OTM).

On January 30, the VIX jumped to almost 21—a high level for its recent history. As figure 1 shows, market makers traded strike prices for call options that ranged from $15 to $25 out of the money.

Why would there be a market for options that were so far out of the money with such a small chance for profit?

The probability that these far OTM options would expire in the money (ITM) was very low—only 14% for the $210 strike price. But remember, the VIX finished high that day, above 20. This means that not only did the index fall far enough to get to that point, but also, traders’ high fear levels signaled opportunity.

One aspect of buying options is that no matter how far the underlying stock moves against you, you cannot lose more than what you paid for the option (the full cost including transaction costs). In this case, the call option at the $210 strike price cost only $84 on January 30. Its implied volatility levels at 13.78% were close to the lowest of any call option, which also reduced its cost.

Finally, its delta reflects the call option’s potential return if the underlying moves $1 per share higher. When delta is compared to the option’s ask price, the $210 call option’s percentage return for a $1 stock move was higher than for any of the more expensive strike prices.

SPY rallied to $210 a share just three weeks after the VIX spiked. The extreme market conditions produced a situation where the S&P 500 made a strong move off its January low. In this example, the $210 call option gained almost 300% from the time when investors were hitting an extreme in fear and anxiety.

As shown in figure 2, when the underlying’s implied volatility dropped back to normal levels on February 20 (from 22% to 15%), the $210 strike price maintained a similar implied volatility level, at 12.72%, compared to January 30. This is another potential benefit to buying the deep OTM call options.

Although out-of-the-money call options may be hard to trade when volatility is low, there are potential opportunities for the cheaper options during market extremes. When traders are running for the exits, consider buying low-probability OTM options and then selling them back when stocks rally to your targets. The low cost may help to manage risk in case the stock doesn’t move as you expect.

The second part of this series will focus on how the “smart” money attempts to take advantage of cheap, out-of-the-money options when market volatility hits extreme lows.