When it comes to the subject of stock options, we are often met with heavy resistance. For many people there is a sense of fear trading stocks options as they are perceived as being risky. However, the bottom line is stock options are a decaying asset which essentially means they are time-sensitive investing instrument which becomes worthless every day the instrument trades until it reaches expiration. So, two-fold goal becomes understanding exactly what stock options are thus removing the fear of using them and how to use the time decay on a stock options to your advantage.
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 into 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 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.
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 which 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 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; buy, hold, and pray. But options are not very forgiving in that area. They require the trader to be more disciplined and 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 capital losses.