In the majority of 2023, volatility has remained relatively low in the financial markets, resulting in slower overall price movements.
However, this low volatility environment presents both challenges and opportunities for options traders. One of the key challenges is that the premium of an option decreases over time. This means that if there is no significant movement in the underlying stock or index, options traders in long positions may incur losses due to the time decay of the option premium.
On the flip side, there are advantages to trading options in a low volatility environment. All options, regardless of their strike price and type (Call or Put), tend to trade at lower premiums. This translates to a lower initial investment required to establish a long position in an option.
To make the most of the opportunities presented by low volatility and slower price movements, traders can focus on selecting the right strike prices. Options can be categorized into three main types based on their strike prices:
1. ATM (At the Money): The strike price is close to the current market price.
2. OTM (Out of the Money): Call options have a strike price higher than the current market price, while Put options have a strike price lower than the current market price.
3. ITM (In the Money): Call options have a strike price lower than the current market price, while Put options have a strike price higher than the current market price.
Now, let's delve into the reasons why Out of the Money (OTM) options can outperform in a low volatility environment:
Reason #1: Lower Investment: OTM options are less attractive because they are essentially options to buy higher (Call) or sell lower (Put) than the current market price. However, this characteristic makes them more affordable, especially in an already low premium environment. The lower investment required to establish positions in OTM options is one of the primary factors contributing to their outperformance.
Reason #2: Higher Returns on Investment:While the price movements are similar for all types of options, ITM options will experience a higher increase in premium than ATM options for a given favorable price move. Similarly, ATM options will see a higher premium increase compared to OTM options. When focusing on the returns on investment (ROI), calculated as Premium Profit / Premium * 100, OTM options tend to shine.
Reason #3: Lower Absolute Loss: OTM options have lower intrinsic value due to their distant strike prices, which means there is less to lose. Consequently, sticking to a single position in one stock or index will result in lower potential losses, making it easier to exit if needed.
In summary, it's the combination of offering higher returns, affordability in terms of entry and exit, and lower potential losses that makes OTM options an attractive choice for trading in a low-volatility market.
Shubham Agarwal is the CEO & Head of Research at Quantsapp Pvt. Ltd. He has extensive experience in various forms of market research and programming in multiple programming languages. Prior to his current role, Shubham served as the Head of Quantitative, Technical & Derivatives Research at Motilal Oswal and as a Technical Analyst at JM Financial.
However, this low volatility environment presents both challenges and opportunities for options traders. One of the key challenges is that the premium of an option decreases over time. This means that if there is no significant movement in the underlying stock or index, options traders in long positions may incur losses due to the time decay of the option premium.
On the flip side, there are advantages to trading options in a low volatility environment. All options, regardless of their strike price and type (Call or Put), tend to trade at lower premiums. This translates to a lower initial investment required to establish a long position in an option.
To make the most of the opportunities presented by low volatility and slower price movements, traders can focus on selecting the right strike prices. Options can be categorized into three main types based on their strike prices:
1. ATM (At the Money): The strike price is close to the current market price.
2. OTM (Out of the Money): Call options have a strike price higher than the current market price, while Put options have a strike price lower than the current market price.
3. ITM (In the Money): Call options have a strike price lower than the current market price, while Put options have a strike price higher than the current market price.
Now, let's delve into the reasons why Out of the Money (OTM) options can outperform in a low volatility environment:
Reason #1: Lower Investment: OTM options are less attractive because they are essentially options to buy higher (Call) or sell lower (Put) than the current market price. However, this characteristic makes them more affordable, especially in an already low premium environment. The lower investment required to establish positions in OTM options is one of the primary factors contributing to their outperformance.
Reason #2: Higher Returns on Investment:While the price movements are similar for all types of options, ITM options will experience a higher increase in premium than ATM options for a given favorable price move. Similarly, ATM options will see a higher premium increase compared to OTM options. When focusing on the returns on investment (ROI), calculated as Premium Profit / Premium * 100, OTM options tend to shine.
Reason #3: Lower Absolute Loss: OTM options have lower intrinsic value due to their distant strike prices, which means there is less to lose. Consequently, sticking to a single position in one stock or index will result in lower potential losses, making it easier to exit if needed.
In summary, it's the combination of offering higher returns, affordability in terms of entry and exit, and lower potential losses that makes OTM options an attractive choice for trading in a low-volatility market.
Shubham Agarwal is the CEO & Head of Research at Quantsapp Pvt. Ltd. He has extensive experience in various forms of market research and programming in multiple programming languages. Prior to his current role, Shubham served as the Head of Quantitative, Technical & Derivatives Research at Motilal Oswal and as a Technical Analyst at JM Financial.
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