When I talk with traders about using stock options I am often met with heavy resistance. Usually it is because people have a hard time conceiving one of the core concepts of options, and consequently they assume they are risky.
For some people the difficulty is in understanding why there are so many strike prices. Many people struggle to understand how to read option chains. Others struggle with seemingly nominal items, such as “why is it called a ‘put’ option?”
It really does not matter why people struggle, the reality is they do. For many people their lack of understanding leads to fear and an assumption that trading options is just too risky.
From my point of view this is quite unfortunate. Many otherwise great traders miss out on some great profit making opportunities simply because the concepts seem overly difficult to comprehend.
One of the biggest concepts people struggle to understand is the reality that stock options are a decaying asset. Consequently people tend to have two reactions:
One response is dismissive of the opportunity and chooses to not even try to understand. The other response is dismissive of the risk and pretends that it is not there. Neither response is rational.
The good, the bad, and the ugly of stock options is this: Stock options are a time sensitive investing instrument that becomes worth less every day the instrument trades, until it reaches expiration.
And yet, while this is a truth of options, still the industry continues to grow and people continue to make incredible money playing this instrument we call a stock option.
So what do we need to know about time decay to be able to use it in our favor rather than against us?
Intrinsic value vs. Time value
The first thing every option trader must understand is that there are two key areas that determine the price of the option: Intrinsic Value and Time Value.
Intrinsic value is the “built in” value of an option. Let’s say Johnny has a $100 Call option and the stock is trading at $110 - this option has an intrinsic value of $10/share. In other words, the $10 is built in to that option. The $100 call gives Johnny the right to buy the stock $10/share LESS than the current stock value. That is built in value.
Intrinsic value is very easy to figure out. It is simply a function of two factors:
The difference in stock price and strike price will always determine the intrinsic value. An option that has intrinsic value is said to be “in the money” while an option that does not have intrinsic value is “out of the money”.
Every option will always have a value at least equal to intrinsic value. If an option were to sell for less than Intrinsic value then it would present an opportunity to simply buy the options and turn around and sell them at fair market value. This will never happen.
While an option may have $10/share intrinsic value the cost of the option will most likely be $11-$13, depending on when expiration may be. What accounts for the extra $1-$3? Time value.
Time Value is the “premium” that a person pays to have the option itself. Think of this like an insurance premium that you would pay on your house or automobile.
Time value is impacted primarily by the following factors:
These two components work together to help determine the premium portion of an option price. They help account for the risk that is being taken on by the option seller.
What is very important to understand when talking about option values is this:
Only time value will decay as an option approaches expiration. Intrinsic value will not be affected by time.
Understanding this we can front load our success by simply buying options that are in the money. In the money options have much higher intrinsic value and consequently are much more stable with a much lower percentage of time decay.
Understanding this concept is key to making money with options and not being the poor soul who constantly buys options only to watch them expire worthless. Most option chains will visually show where the In the money/Out of the money line is so you can easily see which options you should start looking at.
The one thing that many beginning option traders push back on is this: In the money options cost more. People often think that buying out of the money will provide a better profit but in reality while the percentage of profit may be better, the odds of success go down rapidly and make this a very high risk trade.
What is Theta?
To help understand this you can look at the rate of time decay for an option. When you look at any option chain there is a set of numbers we refer to as the “greeks”. In the greeks there is a number referred to as Theta. This tells us the rate of time decay.
Here’s how it works. Let’s say an option has a theta value of .04. What that tells you is this: Every day, assuming the stock stayed the same price, this option will lose .04. And that will continue to happen until expiration.
But the really crazy thing is that the rate of time decay also goes up as you get closer to expiration. Check out this actual theta curve to get an idea.
Notice the closer to expiration the faster the option premium will decay. This is the death wish to an out of the money option.
To be a successful options trader it is very important to understand this component. Many traders like to treat options like they have their stock; simply buy, hold, and pray. But options are not very forgiving in that area. They require the trader to be more disciplined and actually pay attention to what is happening. Otherwise the trader will find him/herself holding an option and watching it go all the way down to zero.
Trading options doesn’t need to be scary. It doesn’t have to be hard and it doesn’t have to be complicated. However trading options does require the option trader to do a little more work learning how the price of the instrument itself is likely to change as it gets closer to expiration.
If you will learn how these things work you will find that options provide one of the best trading tools available to the modern trader. That’s why so many people love to trade them. However, failure to account for these very important details can, and will, lead to massive losses, often the kind from which you cannot recover!
Expand your flexibility and create additional opportunities.