Why OTM Options Are Cheap but Risky for Beginners in Option Trading
In option trading, you may see one option trading at ₹100, another at ₹40, and another at just ₹5 or ₹10. The ₹5 option may look attractive because you can buy more lots with less money. Many of these cheap options are OTM options. OTM means Out of the Money.
OTM options are often cheap because the market still needs to move in your favour for them to gain more value. If the market does not move enough before expiry, they can lose value quickly or even become worthless. So, a low price does not always mean low risk.
First, What Is an OTM Option?
Suppose Nifty is trading at 25,000 and you are looking at a Nifty call option with a strike price of 25,500. The strike price is the price level linked to the option. Since Nifty is below the 25,500 strike price, this call option is OTM.
For a put option, it works the other way. If Nifty is at 25,000 and the put has a strike price of 24,500, the put is OTM because Nifty is still above the 24,500 strike price.
So, an OTM call has a strike price above the current market price, while an OTM put has a strike price below the current market price. An option that is farther from the current market price may be cheaper, but the market also needs to move more for that option to become profitable.
Why Are OTM Options Usually Cheap?
The price you pay for an option is called the option premium. If an option is trading at ₹10, its premium is ₹10. OTM options are often cheaper because the market has not reached their strike price yet, and there is a chance that it may not reach that level before expiry.
For example, suppose Nifty is at 25,000 and you are looking at two call options with strike prices of 25,100 and 26,000. Nifty needs only a small rise to reach 25,100, but it needs a much bigger rise to reach 26,000. Because reaching 26,000 is more difficult, the 26,000 call may be much cheaper.
This low price can attract beginners. But it is cheap partly because there is a greater chance that the market may not make such a big move before expiry.
1. Cheap Does Not Mean Low Risk
An OTM option trading at ₹5 may look like a small-risk trade, but the low price can be misleading. If you buy an option at ₹5 and its price falls to ₹2, you have lost 60% of its value. If it falls to ₹1, you have lost 80%.
If the option becomes worthless at expiry, you can lose the full premium paid for it. So, even a cheap option can lose a large part of its value very quickly.
2. The Market Needs to Move Enough
With an OTM option, getting the market direction right may not be enough. The market may also need to make a large enough move.
Suppose Nifty is at 25,000 and you buy a 25,500 call because you expect Nifty to rise. Nifty then rises to 25,100. Your direction was correct, but Nifty is still well below the 25,500 strike price, so your option may not give the kind of profit you expected.
This is an important part of OTM option buying. The market may need to move in the right direction, move far enough, and do it within the available time.
3. Time Works Against the Option Buyer
Every option has an expiry date, which is the date when the option ends. As expiry gets closer, there is less time for the market to make the move you need. Because of this, an option can lose value simply as time passes. This is called time decay.
For example, you may buy an OTM call expecting the market to rise. But if the market stays around the same level for two days, the option can still lose value because two days have passed and there is now less time for the expected move. This effect can become stronger when expiry is very close.
4. OTM Options Can Lose Value Very Fast Near Expiry
The risk becomes higher when very little time is left before expiry. Suppose an OTM option has only one day left and the market is still far from its strike price. The chance of the market reaching that level in the remaining time may be low.
As a result, the option price can fall very quickly. An OTM option may fall from ₹20 to ₹10 and then from ₹10 to ₹5. If the market still does not move enough, the option may move close to zero.
This is why very cheap OTM options can be especially risky near expiry.
5. A Small Premium Can Make Beginners Buy More
Cheap options can also make traders take more risk without noticing it. Suppose one option costs ₹100 and another costs ₹10. The ₹10 option may look easier to buy in larger quantities, but buying more does not reduce the risk. It can increase the total amount of money you are putting at risk.
For example, a trader may avoid putting ₹5,000 into one trade but keep buying different cheap options for ₹500, ₹700 or ₹1,000. Each trade looks small, but together they can add up to a large amount. This is why a low option price should not make you less careful about how much money you are risking.
6. Beginners May Keep Buying Very Far OTM Options
Options that are very far from the current market price can be extremely cheap, which makes them attractive to beginners. Suppose Nifty is at 25,000. A nearby call option may cost ₹100, while a far OTM call may cost only ₹5.
If the market makes a strong move, that ₹5 option could rise quickly. It may even move to ₹20 or ₹30 in some situations. But the big move may never come, and the option can remain OTM and eventually expire worthless.
So, an extremely low price should not be the main reason for buying an option.
7. One Big Profit Can Give the Wrong Idea
Sometimes a cheap OTM option can give a very large return. An option bought at ₹5 may rise to ₹15 after a sharp market move. That is a 200% rise.
After seeing such a trade, a beginner may start believing that cheap OTM options are an easy way to make large profits. But one winning trade does not show the full picture. The same trader may later buy several other ₹5 or ₹10 options that lose value or become worthless.
Big winning trades are easy to remember, while many small losing trades are easier to ignore. This can make OTM option buying look easier than it really is.
Can an OTM Option Become Profitable?
Yes. An OTM option is not automatically a bad trade. If the market makes a strong move in the expected direction, the option price can rise.
For example, if Nifty is at 25,000 and you buy a 25,500 call, the call price may rise if Nifty starts moving strongly higher. Other factors can also affect the option price, but for an OTM option buyer, the market often needs to move enough within a limited amount of time.
This is why you can be correct about the market direction and still lose money if the move is too small or takes too long.
What Happens to an OTM Option at Expiry?
Suppose you bought a 25,500 Nifty call and Nifty is at 25,300 when the option expires. The call is still OTM because Nifty is below the 25,500 strike price. In this example, the option can expire worthless, and the premium paid to buy it can be lost.
If you paid ₹20 for that option and it expires worthless, its value goes to zero. This is why you should not buy an option only because its premium looks cheap. You also need to understand what the market needs to do before expiry.
Why Do Beginners Like OTM Options?
Low price is one of the biggest reasons. An option trading at ₹5 or ₹10 looks affordable. Another reason is the possibility of a large percentage return. If a ₹5 option rises to ₹10, its price has doubled.
Social media can also make these options look attractive. You may see screenshots showing an option moving from ₹5 to ₹50. But such screenshots do not show all the options that moved from ₹5 to ₹1 or became worthless.
Looking only at the big winners can give the wrong idea about the actual risk.
What Should a Beginner Understand Before Buying OTM Options?
Do not buy an option only because it is cheap. First understand why it is cheap. Check how far the strike price is from the current market price, how much time is left before expiry, and how much the market needs to move.
Also remember that the option premium can fall even if the market does not move strongly against you. Before taking a trade, decide how much money you are prepared to lose. A small option price does not automatically mean a small risk.
Final Thoughts
OTM options can be attractive because they are cheap and can sometimes give large returns. But their low price comes with risk. The market may need to make a large move before expiry, and if the move is too small, takes too long, or does not happen at all, the option can lose most or all of its value.
Time also matters. As expiry gets closer, a far OTM option can lose value very quickly. So, instead of looking at a ₹5 option and thinking it is cheap, look at why it is cheap.
Check how far the strike price is, how much time is left, and how much money you could lose if the expected move does not happen. Cheap options can give large returns, but they can also lose most or all of their premium. A small price should never make you ignore the risk.
A cheap option does not always mean low risk. Before buying an OTM option, understand how far the strike price is, how much time is left before expiry, and how much of the premium you could lose.
