Evaluating out-of-the-money strikes with saddle premiums and implied volatility

Out-of-the-money premiums can fall as the underlying rises

An out-of-the-money-option is a call struck above the underlying or a put struck below it, and it expires at zero if it remains out of the money. Out-of-the-money calls can stay unchanged or lose value even when the underlying rises. That drag is strongest in the nearest series as expiration nears and implied volatility declines.

Cheap deep out-of-the-money front-month calls are framed as needing both a large move in the underlying and a rise in implied volatility. That combination is treated as uncommon.

Flag a strike by its neighboring premium gap

A candidate strike is flagged when last, bid, and ask quotes show a sharp premium gap versus the neighboring strike. That neighboring-strike-premium-gap is used to mark a contract for further evaluation, not to complete the choice on its own.

Keep enough life for implied volatility

Series with less than three weeks to expiration are excluded from this speculative screen. If the front month has only 10 to 15 days left, the next series with about 40 to 50 days is preferred.

This expiration-horizon-filter leaves room for an implied-volatility-overlay: judging an out-of-the-money premium by how implied volatility typically fades into expiration or expands on a large move in the underlying.

Rank expected P/L against premium at risk

A rapid rally can be screened with a modeled-strike-shift. Each call’s price is moved to the current market of the next-lower strike so expected outcomes can be compared across the chain.

After a 100-share multiplier and a 5-dollar commission, candidates are ranked by expected P/L divided by maximum-risk. Maximum-risk is the capital exposed on a long option, taken as today’s premium scaled by contract count. The ranking statistic is the p-to-r-ratio: expected profit and loss after charges, divided by that maximum-risk figure.

The saddle-point is the strike whose risk-reward reading exceeds both neighboring strikes after that modeled one-strike premium shift.

A historical listed-chain illustration

In the 12 November 2002 IBM chain, with the stock near 78.51, the December 90 call’s p-to-r-ratio exceeded both adjacent strikes and was treated as the saddle-point. The April 95 call’s higher p-to-r-ratio was set aside because of larger time value.

The same screen on puts

A sudden drop in the underlying is described as arriving with higher implied volatility, which may let an out-of-the-money long be closed without a loss even if the asset is below the entry level. The same neighboring-premium and risk-reward screen is stated to apply to out-of-the-money puts as well as calls.