Mastering Derivatives: Choosing The Immediate OTM Strike

Trading futures is relatively easy compared to options. For one, futures move nearly one-to-one with the underlying. So, all the trading tools used for stocks can be applied on futures prices. For another, the choice of contract is simple: you pick the near-month contract unless you want to set up a spread trade. Trading options, on the other hand, is more complicated. This is because options suffer from time decay. So, you must balance the loss in time decay with the probability of the option ending in-the-money (ITM). This week, we discuss why you can choose the immediate out-of-the-money (OTM) strike to initiate a long call position when you have positive view on the underlying.

Delta-theta trade-off

An option’s time value will become zero at expiry. So, the amount you pay today for time value will be your loss if you hold the option till expiry. Your objective then would be to pay only so much for time value that is required to trade gainfully. That means whatever you lose through time value should be made up through delta gains. Delta is the change in the option price for a one-point change in the underlying price. The strike that you buy must have just enough delta to push it from OTM to ITM when the underlying moves up.

Importantly, you should not buy a strike that is ITM because there is no benefit in paying full price for an option’s intrinsic value. Rather, you should buy the strike that has no intrinsic value now but will become ITM as the underlying moves up. Why? Intrinsic value moves one-to-one with the underlying. So, the gains from intrinsic value can more than offset for the loss in time value. The strike that can offer this trade-off is the immediate OTM strike. So, you should check the price of the underlying and pick the strike immediately above it. The delta of this option will often be close to 0.50. Technically, that would be the at-the-money (ATM) strike. Note that the option’s delta will increase and move towards one as the strike becomes more ITM. You should, however, close your position when the strike is ITM by not more than 150-200 points for the Nifty Index options. This is because liquidity of strikes decline, as options become more ITM. And liquidity is important to close positions at a fair price, as options you buy on the NSE are European and can be exercised only at expiry.

Optional reading

There are other benefits of buying the immediate OTM strike. As an ATM strike, it will have high vega and gamma. That means the option will change the most if implied volatility explodes. The higher gamma value means that the option’s delta will rise faster when the underlying moves up and will fall slowly when the underlying declines. The flip side is that the option will carry high time value that totally decays at expiry.

(The author offers training programmes for individuals to manage their personal investments)

Published on January 31, 2026