Deep Out-Of-The-Money Options: A Calculated Risk

The trading strategy of purchasing a deep out-of-the-money call or put option has been referenced as purchasing a “lottery ticket”. Both present an opportunity for profits but with a low rate of success. Depending on how far out-of-the-money the strike price and time remaining until expiration, it would take a considerable move in the underlying futures market to profit. However, this trading strategy should not be discredited — especially if past performance provides an opportunity for future results.

Refer to the Japanese Yen futures contract for an example of purchasing a deep out-of-the money put option with opportunity to profit. Daniels Trading recently released a report titled “Preparing for a Yen Reversal“. This succinct report laid out a fundamental reason to take a bearish stance in the Japanese Yen futures contract: a strong Yen has a negative impact on the Japanese economy, an economy that is still reeling from the March 2011 earthquake and tsunami disasters. Japanese officials are clearly looking for a weaker Yen to help stimulate their economy and to aid recovery efforts.^[1] The key weapon deployed to weaken the Yen has been central bank intervention.^[2]

Review the arrows on the chart below. On March 18th, August 4th, and October 31st, central bank intervention evoked the market to sell-off hundreds of points (453, 518, 635 respectively) from the opening price.

The Yen is currently finding support as a “flight to quality” currency during the last few months due to the US budget concerns and Euro zone issues with sovereign debt. However, a central bank intervention could perhaps provide the one day volatility needed to profit on a deep out-of-the money put option. Referencing the chart above, this situation occurred in the past. Today, (11/23/2011) I recommended purchasing the March 2012 Japanese Yen 120 put option for 33 points or $412.50. This option provides 107 days until expiration while holding for a potential central bank intervention. With another daily 500 point move the delta on the 120 strike price could potentially triple in value, which in turn could potentially triple the profits. On the day of a central bank intervention simply liquidate the position while volatility is at its highest. If a central bank intervention does not occur in the timeframe, the risk is only the premium fees paid up front. A risk under $500 is well worth this calculated “lottery ticket.”