Continuation of the previous analysis on OTM calls — Courtesy of Adam Warner at Daily Options Report.
Upon Further Review
Some further thoughts on this CXO piece.
Academic papers obviously study problems in a theoretical vacuum. Real world of course differs. I’ve traded options for a while now, and I believe this one gets the gist right. That is, further OTM options provide weaker returns than closer to the money ones. But it may also get the specifics a bit wrong.
Namely, it looks at options as a zero sum game. Which is correct if all anyone every did was buy and sell an option once and never touch it, or do anything against it in the stock or another option. But in reality of course an option owner now has some ammo to fade moves in the stock. He may hedge immediately or he may wait until it gets closer to the money, or he may never do a thing and indeed watch it go to wallpaper.
Let’s say we have a fixed amount of money to risk, and we are deciding between buying fewer, ATM options or a greater quantity or further OTM’s. And let’s say the stock runs, but maxes out at or near the higher strike, but closes such that the ATM’s are now in the money and profitable, but the OTM’s go out worthless. In theory, the ATM’s were the better purchase. But were they in practice? Very tough to know, but I suspect and aggressive hedger would have sold stock too soon against the ATM’s, while that same person may have let the stock rally a bit further before he sold against the OTM’s.
When I was a market maker on the AMEX, basic order flow always got us long buckets of OTM call options. The tendency was always to underhedge them, i.e. not sell as much stock as the models told you you needed to sell. Basically because they didn’t move much up or down until the stock got close, so your risk tended to be hedging too soon, not failing to hedge. Of course I was a market maker in the 90’s for the most part, so stocks tended to all eventually rally, so things may be different today.
But that’s not really my point. What I’m trying to say is the ultimate profitability of an OTM call purchase it likely understated in the study. Not to the point that they are incorrect; OTM’s do not make a good investment, but that underestimates their utility as a trading vehicle.
