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Picking Up Cheap OTM Puts

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With the market continuing to grind higher and become more and more overbought each day, it’s seems like this rally will never end. One thing I like to do in this situation is start picking up some long-dated, cheap out-of-the-money puts.

Volatility is so low right now, that you can buy puts with 3-6 months to expiry very cheaply. I’d be willing to allocate about 0.5% of my total capital to cheap OTM puts, then add another 0.5% in around 2-3 weeks time if we continue to rally.

I would look at puts with delta around 5. Anything less and they won’t move much if we get a selloff, but they are still cheap enough that you can pick up a couple of contracts and not break the bank.

It’s a fair bet that sometime within the next 3-6 months we will have some kind of selloff (even if it’s only 5-8%) so picking up cheap puts now gives you some protection when that occurs.

The great thing about these cheap puts is that when a selloff does come, the rise in volatility means the premium on these puts goes up pretty quickly. There is usually a mad scramble as traders try to protect their portfolios and that sends the price of the puts shooting higher.

You can currently pick up some SPX Dec 1700 puts for around $7.20. These have a delta of 7.

The strike price is 15% away from the current price, but all you need is a short 4-5% correction some time in the next few weeks for these to come out ahead.

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5 Comments
  1. Lawrence says:

    Gavin

    How do we know when the retracement or correction come after a rally? Normally, TA technicians may draw a Fibonacci retracement ratio at 32.8%, 50% and 61.8%.

    OTM option can be expensive when IV option volatility and HV for stock volatility are high for certain stocks or ETF.

    My question is how cheap is cheap for OTM option compared to VIX or major indexes option? I is quite subjective and everything is relative to each other. sometimes, the current / front month or weekly option are more expensive than the back month.

    4 to 5% correction in SPX or RUT or NDX is big move, maybe buy the debit spread is a better option to avoid time decay.

    1. Gavin says:

      Hi Lawrence, typically OTM puts have a much higher volatility and are therefore more expensive on a relative basis than their OTM call counterparts. OTM puts are more expensive because there is more of a likelihood of a crash down rather than a crash up. Investors are willing to pay more for crash or “Black Swan” protection.

  2. The concept is good for anyone who has a bearish bias. Yet, when it comes time to making the trade, $720 seems like a lot of money for a 1-lot.I prefer the idea of buying OTM put spreads — even with its limited profit potential.

  3. Rocky says:

    When I go to SPX and look at Dec 16 1700 Puts the price is 57.20 and delta is .18. At a delta of .07 at 1400 Strike price is 23.10. I must be missing something or do I need to wait until market opens. Using TOS.

    1. Gavin says:

      It will be different when the market opens.

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