“Deeper OTM Puts are considered as ‘most expensive’ options”: What Does This Really Mean?

In my post “Volatility Smile and Volatility Skew – Part 1”, it is mentioned as follows:

For Put options, the Implied Volatility is typically the highest for deep OTM options and then is decreasing as it moves towards ITM options.

In other words, generally the “most expensive” options are deep ITM Calls and deep OTM Puts.

For Put options, the possible reason why people are willing to buy an “expensive” deep OTM Puts are that they are viewed as a form of “insurance” against market crash. The lower cost in terms of dollar might also offer another reason for deep OTM Puts to serve as an insurance / protection tool of one’s portfolio.

As discussed earlier in this link, an option is deemed cheap or expensive not based on the absolute dollar value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is expensive, whereas when the IV is relatively low, the option is considered cheap.

For deep ITM Calls, even without understanding the above concepts, people won’t really question why they are deemed “most expensive”, as the options premiums are also higher in terms of dollar.
However, for deep OTM Puts, those who are not aware the above concepts will be wondering why deep OTM Puts is considered “most expensive”, as the options premiums are actually low in terms of dollar value.

In this post, we’ll focus on discussing OTM Puts, by comparing less-deeper and deeper OTM Puts.

As deeper OTM Puts normally have higher IV than less-deeper OTM Puts, deeper OTM Puts are therefore considered as "more expensive".
However, this does not mean that the premium of deeper OTM Puts will be higher in terms of dollar.

This is because an option's premium is affected by 6 factors, not only IV.
As discussed in the previous post (i.e. Options Pricing), other important factors that determine option’s price are option’s strike price & current stock price.

Although deeper OTM Puts is higher in IV (and hence it's considered "more expensive"), their option premium will be lower in terms of dollar than less-deeper OTM Put options.This is because deeper OTM Put options' strike prices will be much farther from the current stock price, as compared to less-deeper OTM Puts would.
As a result, deeper OTM Put options will have much lesser chance / probability (almost no chance) of becoming “In-The-Money (ITM)” before expiration. Or in other words, it is almost certain that the deep OTM options will not finish ITM.

Remember that for OTM options, option premium will only consist of Time Value component.
(Please see this post – Option Price Components – in case you need more clarification).

As previously mentioned in this post (More Understanding about Options Time Value):

Time value can be viewed as “the price that people are willing to pay for the chance / uncertainty as to whether or not an option will finish In-The-Money (ITM)”.
The more uncertain, the higher the time value will be.

An option that is far OTM has almost no chance of finishing ITM. As such, it will not command a high time value.
An option that is already deep ITM is almost certain that it will finish ITM, hence time value is smaller.
But ATM or near ATM options have more uncertainty as to whether or not the options will finish ITM, and therefore these options have a higher time value.

Hence, in this case, higher IV increases the time value of deeper OTM Puts. However their overall premium will be lower than less-deeper OTM Put options in terms of dollar, particularly because of lower uncertainty (almost no chance) of the deeper OTM Puts to finish ITM before expiration, as they have farther option’s strike price from current stock price.

To understand more about other aspects of Implied Volatility, go to: Understanding Implied Volatility (IV).

Related Topics:
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Option Greeks