Basic Points

• When options are OTM (out of the money), then they have a lower chance of profiting but they cost less in premium. They also have a higher and steeper ratio of reward to risk. This is because if the price does not become ITM (in the money),  then it will end up being worth zero at the end of the option’s contract.
• For an explosive reward potential but at a lower chance of success, buying an OTM option is a reasonable way to go. 
• Like buying any option, you can only lose the total price paid for the option. 

Intermediate: Theory and Assumptions

Our models at SG (outside of the Equity Hub™) use the assumption of puts as dealer-short on both stocks and indices. This means that if puts have increasing implied volatility (IV), and those are OTM short puts for dealers, then what the IV expansion does is bring all strikes closer to 50 delta. An OTM strike (something below 50) will have increased deltas. For market makers, IV increasing means more bullish deltas on their short puts, which means more selling of the underlying security (and therefore a bearish flow on the market). 

Advanced: Strategy

Out of the different types of moneyness (in the money, at the money, or out of the money), the most aggressive is trading OTM options. Those looking for highly convex payouts want OTM options, which have the largest percentage changes as IV moves because they consist entirely of extrinsic value. In contrast, ATM (at the money) options have the largest point changes when implied volatility IV moves (Natenberg, 2015, p. 92). 

Premium sellers are willing to be counterparty to potentially convex flows because they see a sharper skew to capitalize on and help with the overall edge, however this does subject them to risk of ruin unless using expert risk management. 

OTM options also have a lower premium, which is the max loss for the option holder, and the starting credit for the writer. This smaller max loss is very attractive to the options holder and helps to make up for how OTM options have the lowest percent chance of winning. 

Expert: Dynamics

OTM puts consist entirely of extrinsic value, even though they have less total extrinsic value than ATM options. For those going long OTM options, they have a higher potential reward for less risk, but with the perk of defined risk (a max loss). And for those going short options, there is a majority chance that they will hit max profit, but in exchange there is less potential max reward and for more risk. This risk is unlimited unless there is a proper spread in place, such as a vertical with either a backspread (long more options than short) or a vertical (long as many options as short). 

One way to get an edge with writing options (selling them to open) is to wait until IV is greater than RV (realized volatility). But to avoid a risk of ruin and benefit from protections of ergodicity (safely benefiting from the averages), using wingtips to define the risk can be the difference of survival or ruin.