DOTM (Deep Out of The Money) Options

[MTE]

Quote from Chagi:

This doesn't make sense to me. My understanding of options is that someone initially sells (writes) a put/call, which causes open interest to increase by 1. The option is then offered on the market (or sold at the bid to a MM), someone else can then come along and purchase at the ask (or put their own bid up I suppose).

So, that said, can you explain how it is that MMs would sell as many contracts as one wants when there is a buyer? Are the MMs then both liquidity providers and options writers in the market?

Actually, Open interest increases/decreases only in two cases.
1. If a buyer opens a new position and a seller opens a new position (open interest increases)
2. If a buyer is closing an existing position and a seller is closing an existing position (open interest decreases)

That's it. In other cases where one side is opening and the other is closing open interest will not change.

Option writer is anyone who sells an option - MM, retail trader, institutional trader and etc.

I think you misunderstand the concept of how options trade.

Selling (writing) an option is one transaction. I put in an order to sell a call and once someone buys it (MM or someone else) I have sold (written) a call. An option contract does not exist until there's a transaction between a buyer and a seller.

 

[MajorUrsa]

Quote from SleepingGiant:


4) Unlike ATM or slightly OTM options, this premium doesn't have any (at least minimal) time decay or vol effect (at least before it starts to move toward ITM). So if you're wrong about the market direction or the market just sits in a range, you're not losing money due to time or volatility (or you shouldn't be losing much). DOTM (at least initially) seem to be a pure directional (delta) play which is what a trendfollower would want.

All options have a theta, and to have the same delta as in an ATM deal, you'll have to buy a lot more DOTM options then ATM's. The theta/delta ratio is actually higher for DOTM's.

Ursa..

 

[Profitaker]

Quote from torontoman:

Concerning black swans...what do you traders think about sell dotm options where the Black Swans wil not occur. eg S&P calls, silver outs, oil puts etc. What can cause these black swans?

Depends whether or not you believe in black swans, and then whether you believe the higher DOTM vols pay for them. Personally I'm undecided, I just know I can't take on the leverage of shorting them. As for buying them, I can't wait a lifetime to be proved right.

Incidentally, I understand that the financial markets volatility surface was generally flat before the 1987 crash. Anyone confirm this ?

Quote from MajorUrsa:

All options have a theta, and to have the same delta as in an ATM deal, you'll have to buy a lot more DOTM options then ATM's. The theta/delta ratio is actually higher for DOTM's.

Ursa..

I think all greek values are at their largest when ATM, that is except the delta, which decreases as you go OTM.

But if I've read you right you're actually saying that if you want the same delta using OTM options, the position will be much larger (because you will be buying alot more of them), so you're theta value is higher ? Just thought I'd check, because it can get confusing !

 

[riskarb]

Quote from Profitaker:

Incidentally, I understand that the financial markets volatility surface was generally flat before the 1987 crash. Anyone confirm this ?
I think all greek values are at their largest when ATM, that is except the delta, which decreases as you go OTM.

Yeah, it was flat to favoring calls. Amazing what we take for granted with all this curvature. I was only 21 at the time, but I recall the skew inverted before the crash due to nascent portfolio insurance strategies.

 

[riskarb]

Quote from MajorUrsa:

The theta/delta ratio is actually higher for DOTM's.

Ursa..

Correct, but somewhat moot w/o taking into account the leverage to gamma. Take a look at some DOTMs under VaR and a flat vol-surface. It's interesting to visualize. OTM gammas carry much more curvature than theta. ATMs are linear, however[theta/gamma].

 

[Profitaker]

Quote from riskarb:

Take a look at some DOTMs under VaR and a flat vol-surface. It's interesting to visualize.

Would a flat vol surface be a realistic assumption when running a VaR ? I would have thought not, since you'll be moving to the ATM vol. Is there a general calculation for this volatility shift scenario in VaR ?

 

[MajorUrsa]

Quote from riskarb:

Correct, but somewhat moot w/o taking into account the leverage to gamma. Take a look at some DOTMs under VaR and a flat vol-surface. It's interesting to visualize. OTM gammas carry much more curvature than theta. ATMs are linear, however[theta/gamma].

Yes, the change in gamma is very favourable of course.

I forgot to say, but I think SleepingGiant's idea of emulating a Turtle type system with (D)OTM options has some merit.

Quote from Profitaker:


But if I've read you right you're actually saying that if you want the same delta using OTM options, the position will be much larger (because you will be buying alot more of them), so you're theta value is higher ? Just thought I'd check, because it can get confusing !

That is what I meant. But as Riskarb pointed out, it is not as bad as that because your gamma increases quickly as the OTM's get closer; your delta will faster grow than you expect. Exactly why it is so dangerous to sell DTOM's.

Ursa..

 

[Profitaker]

Quote from MajorUrsa:

That is what I meant. But as Riskarb pointed out, it is not as bad as that because your gamma increases quickly as the OTM's get closer; your delta will faster grow than you expect. Exactly why it is so dangerous to sell DTOM's.

Ursa..

Do you guys ever use the 3rd derivative in your calcs ?

 

[SleepingGiant]

Quote from MajorUrsa:

All options have a theta, and to have the same delta as in an ATM deal, you'll have to buy a lot more DOTM options then ATM's. The theta/delta ratio is actually higher for DOTM's.

Ursa..

All true, but I'm not sure that is relevant to this particular situation.

I am not proposing that a trendfollower replicate the delta of an ATM option by using DOTMs. I'm simply saying that the majority of a trendfollower's profits come from massive moves. So, why not play simply for those big moves in as cost effective and low-risk way as possible? DOTM options provide this. In percentage terms, given an extreme move, the payoff for the DOTM option will be a lot more than the ATM option.

Now, as to how many you buy (or what your aggregate delta would be for a given position), I guess that's something that would have to be worked out. Going back to your point, I guess you could buy enough DOTM options to equal the delta of an ATM. I just don't think it is necessary for the strategy to be effective.

 

[MajorUrsa]

Quote from Profitaker:

Do you guys ever use the 3rd derivative in your calcs ?

You mean the change in gamma? It's not part of my set of my set of continuously calculated numbers, so no, I wouldn't be able to give you a value in realtime. But I'm fully aware of its properties .

Actually, I only keep constant track of IV and delta (the other greeks are calculated but I hardly look at them), just to have an idea where my position is on the scale. I also use delta as a way to decide on hedging/rolling points, nothing scientific, just a way to force a decision.
And I have an actual spot pricerange-number visible, so I always see what a 1 and 2 IV move will mean in the time before expiration. This just to have some idea, but also to remind me not to get complacent.

Ursa..