Out-Of-The-Money Options – Pitfalls and Benefits
The lure of the out of the money option is a vagary of human nature. It is so easily understandable that such far- fetched possibilities are judged with clarity by those on both sides of the argument. However, the issue is risk, and for the buyer of an out of the money option it is clearly a limited risk proposition, but still one that according to the laws of mathematical probability, will most likely result in loss. The seller however, has little respite from their own conscience, due to the fact that an out of the money option is necessarily one that has dramatically reduced time value; for the benefit of a small premium, the seller has accepted unlimited risk should the option fall in the money.
Given both these extremes, the issue remains one of value. The option model will invariably utilize binomial pricing, that iterates through a multitude of contingencies that are classified and re-classified into a decision tree. Ultimately, the out of the money option is one that has to successfully negotiate so very many decisions in a consecutive fashion that it is deemed to be unlikely. To this end, the pricing model will discount these rare events to an increasing extent as the strike price gets further away from the at the money strike.
Again, the pricing model reveals a limitation. The anomaly is evident when it is borne in mind that simply because something is improbable, this of itself is no reason to assume that it is impossible. Further, to accelerate the improbability simply due to an event being more unlikely is unsound; if anything the improbability ought to be applied in a linear fashion. If an event is unlikely, there is nothing to be gained by differentiating that improbability into further degrees; the fact remains that it is unlikely.
This over compensation of the pricing model effectively places the tails of the bell curve at an almost indistinguishable distance from the horizontal axis. While this depiction of chance is rarely scrutinized due to the fact that these events are indeed rare, the limitation of the pricing model is exposed to be an underestimation of the possibilities at either extreme of the market.
As such, out of the money options are routinely undervalued by the pricing model, and while a buyer may not be particularly led to invest in such rare occurrences, a seller would do well to inflate the theoretical price in apprehension of entering into a transaction.




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