The point is you said that DOTM's had hardly any time-decay. But if your strategy tells you to buy 1000 shares, you would buy about 20 ATM options or maybe 200 DOTM ones. The time-decay on the 200 DOTM's is bigger than that on the 20 ATM's. If time-dacay was your only concern you'd better buy ATM's. Maybe the method is less risky because of the gamma properties, but not because of time-decay. Ursa..
As it has been pointed out a number of times in this thread, the main problem is liquidity. Let's suppose for argument's sake that you run a fund with $1b. So assuming that your position sizing plan states that you can only risk 1% of that on any one trade (I'm oversimplifying, but it doesn't really matter). So, you now have a position size limit of $10mil. Let's further assume that you want to purchase DOTM calls, which currently trade at 1.00. Therefore, you're looking at buying 100,000 contracts in an illiquid DOTM option. Try getting that without moving the market against you. Besides, 100,000 open interest in a DOTM option will really stick out, so everyone will know what your intentions are.
I agree that liquidity is a problem. And I thought about the open interest issue yesterday. I agree with you there too. Anonymity is one of the benefits of trading the underlying. The funny thing is though that even if everyone knew you were long DOTM premium, I'm not sure if the market place would gain a sizeable advantage from that knowledge (they might even try to front-run you and move the market in your favor). In the futures, if the market knows that a "big player" is long (for example), the market could try to push them offside and force them to dump (sell) the position causing a massive move down with lots of volatility. But if you're long DOTMs, the risk/reward ratio for the market to move the position against you is very poor. What the market gains versus how much they would have to move the market to get you to puke some DOTMs seems a little lopsided (in favor of the DOTM buyer). I don't think the market has the same incentive to move the market against you if you're long DOTMs versus long futures. As for position size. Hmmm... Buying 100,000 DOTM options would be a lot. But, here's what I'm thinking. Because the potential return on a DOTM option is huge (in percentage terms), I don't think they need to buy 100,000 options. I'm thinking they can trade a relatively small position (small both in terms of capital/margin used as well as number of options bought) using DOTMs and still get the same return as a large (and more risky) futures position. But can you imagine the return on a 100,000 DOTM position when it goes ATM/ITM? Unbelievable!!!
A very valid point about time decay. Maybe the trendfollower should adjust their position size to take into account the the potential payoff. In other words, I don't need to buy 200 DOTMs to have the (potentially) same payoff as buying 1000 shares. In fact, if the trader is right, the payoff on the DOTMs would probably dwarf the payoff of the shares. So if I would normally buy 1000 shares maybe I only buy 50-100 DOTMs (instead of 200) as a substitute. What's your thoughts on this?
I routinely buy 100,000 contracts. Sometimes I buy 200,000 contracts if I have some laying around in my account. No liqudity problems.
Yes, I agree with that. The gamma advantage you posess in the DOTM's should play its part in the strategy. Wouldn't know how to quantify that. Also depend on the trading-system you use; many of these systems have positionsize/moneymanagement as essential parts of the strategy; this should be incorporated in your buying choice to have some 'logical' quantity of options known at any time. Ursa..
================ Sleeping Giant; Good thinking in some respects and ; actually initial price is cheap, but practicaly DOTM are THE most exspensive, cutting loss or taking a profit. Also probability of profit on DOTM is much much , much less than underlying. Plenty of reasons why the demand /supply isnt much for deep OTM; and if you went to sell, before the few times they went ITM, bid /ask = huge % of premium Not every trend is a home run, when its time to take what the market gives you ITM,ATM or even slightly OTM is much , much better than deep OTM.