Just wondering whether a strategy involving the consistent buying of inexpensive, deep out the money options just to profit from rare spikes in volatility (that may shoot the price up for the option x10 or even x100 times) is worth it or not? Or do the frequent premiums eat away any large profits that may occur once or twice a year?
If you buy DOTM options you are expecting a big move on the underlying more than any "spike in volatility". Forget trying to catch any 100x moves. You might get lucky with some 5x moves, maybe even a 10x by buying the weekly options a few strikes OTM.
You are wrong. It certainly does work. First, you have to be right once and make some monye on an event. You present it as premonition to raise capital, charge 2% and buy tails. When you run the capital to zero, you close the fund and re-open it. Repeat prior step as necessary (as long as you can find enough willing idiots). Eventually, you'll catch that 1-delta event, which is when you crow and beat your chest. Then you raise even more capital. Eventually, you write books that can not be read without a thesaurus and retire to a nice villa in Mediterranean.
Brilliant idea! Excuse me, can't talk, as I am gonna be busy "lather/rinse/repeat"-ing all the above for a while now...
The literature has quite definitively shown that OTM puts are overprice based on realized volatility. Which would tend to indicate that either a lot of people are pursuing this strategy or just buying "insurance". In either case, it would indicate that this isn't an optimal strategy. Even if it was technically a statistically positive strategy, by definition these events happen so rarely that you'd need to be investing over at least several decades for it to pay off. There are far easier ways to make money in human working lifespan timeframes.
Every option is overpriced based on realized vs implied analysis, yet that premium persists. There is value is convexity (long vol is better then short vol) and people are willing to pay for it, so volatility is structurally rich. As for far OTM, I've yet to see a single convincing study that shows that far OTM options are overpriced - given the frequency of those events, they all boil down to statistical masturbation.
It's actually a well established phenomenon, only in the S&P 500 though. Take a look at http://www.investps.com/images/Why_Are_Put_Options_So_Expensive.pdf which was the original paper. There have been some alternate explanations postulated but none that I find completely satisfying. The paper's been cited over 150 times, none of which have accused the author of "statistical masturbation", maybe you can be the first to write that paper?
Far OTM put options are rarely overpriced in equities based on the implied statistical distribution versus the historical returns. Indices, inherently more diversified, can present a volatility risk premium alpha, but always be prepared for the short gamma/vega risk to be realized.