The Price of Out-of-the-money Options

I'm going to consider now the case of call options expiring this week that have been going in and out of the money during the past few months. Again, this is the price of the underlying security (Microsoft stock) during the past six months:


The call at strike $27, MSQ-AS, was in-the-money the first half of August and for most of November through the first half of December. The same trade examined in my previous post would yield now (1.6-0.3)/0.3 = 433%.


Moving further out-of-the money, the call at strike $27.5, MSQ-AY, who was at-the-money the second half of November, would yield, doing the same trade, (1.3-0.25)/0.25 = 420%.


And, if I consider a call that was always out-of-the-money, MSQ-AT, with strike at $29.5, I get with the same trade (0.4-0.1)/0.1 = 300%.


If I compare the price of out-of-the-money calls with the in-the-money calls seen in the previous post it jumps out that it is not just much cheaper but it follows the underlying security only qualitatively, the more so the deeper out-of-the-money it is. More to the point, it clearly depreciates as the expiration date comes closer, no matter what the underlying security is doing, and the depreciation becomes more pronounced the more out-of-the-money it is.

Therefore, it appears that the best yield on a trade of this nature is not necessarily obtained by picking the cheapest contract. In fact, a contract that it is only moderately out-of-the-money and that is more likely to get in-the-money for certain periods of time, is the best pick.

Moreover, the general price behavior of calls out-of-the-money becomes increasingly similar to a penny stock the more out-of-the-money they are. Just compare the graphs above with the ones posted in the companion blog "penny stock scams".

Categories: stock options
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