A deep out of money option is like a lottery ticket. If you used the at the money estimate of implied volatility to hedge it, you would be in for a rude shock when volatility moves against you. If your timing is right and you had bought the options before market volatility moved you would really strike it rich.
But don’t take my word for it. Here is a simplified and contrived example that illustrates the point.
Let’s assume that we are interested in buying call and put options on our favorite OIL ETF. Oil recently has not been as volatile and we believe that there is going to be a significant jump in volatility given the cyclicality of this market. Current implied volatility levels are at historic lows at 6.8%. To keep our model simple we assume that the convenience yield is zero.
In the above grid, you want to focus on the five cells circled in red. When we play the scenario we have in mind, these five numbers will move. Right now you can buy a call on your ETF for 1.2 cents at a strike price of 120 with an implied volatility of 6.8%. A deep out of money put struck at 70, is currently worth zero.
Let’s assume that Libya implodes again driving Brent prices through the roof. There is a change of heart in Saudi Arabia against pumping 11 million barrels a day and they decide to cut production by a few million barrels and Russia peeved by the burden of western sanctions decides to impose a unilateral oil and gas embargo on Western Europe after finding a new market for petrochemical products in China.
Implied volatility jumps from 6.8% to 25%. Here is the corresponding change in the value of our options. Since this is a contrived scenario, you can see that there is no change in the underlying spot price. We will change that in the next panel.
When you plug in the impact of changes in spot price on account of the oil volatility scenario playing out, here is what the final value of your option positions looks like.
So our 1.2 cent deep out of money call option is now worth US$15.439.
If you had sold this option and tried hedging that with the at the money implied volatility estimate at time zero, you would be in deep trouble now.
From an option investing point of view, it also creates an interesting question. If you are allowed to trade premiums as you are with American options, from a pure risk return perspective which option positions are you likely to favor. At or near money options or deep out of money options? How does that preference change when volatility is at historical highs versus historical lows? How do these preferences vary across novices and experienced professionals and what does that do for supply and demand for deep out of money options? Try and answer these questions before we move on to our next lesson on building volatility surfaces.