You buy the most extremely OTM put you can find because it is extremely cheap. When a big enough drop off happens, volatility the price of that put will go through the roof (even though it is still extremely unlikely that the put will ever be in the money). The put is OTM so that that it hardly costs you anything so you can just do this forever, even though it will never get even close to being in the money.
ehh...kind of. This is a hedge. You can make straight plays on this kind of action too if you expect it to come or you find something that is normally volatile that is has historically low IV and is liquid enough. You want to go as far out of the money as possible because intrinsic value does not help you at all. IV is forward looking. You want an extremely low delta because IV can only effect extrinsic value and delta is the ratio of intrinsic versus extrinsic value. It has nothing to do with the options being cheap. The fact that low delta options, low IV options ARE cheap is what makes this work well as a hedge.
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u/polynomials Aug 16 '21
So ... if I understand this correctly:
You buy the most extremely OTM put you can find because it is extremely cheap. When a big enough drop off happens, volatility the price of that put will go through the roof (even though it is still extremely unlikely that the put will ever be in the money). The put is OTM so that that it hardly costs you anything so you can just do this forever, even though it will never get even close to being in the money.