Buying options where the underlying stock has very little movement.
Letting profits evaporate due to time decay (theta).
I will be discussing in key examples what we mean in the above mistakes and provide some helpful insights on how to trade options more efficiently for income.
1.Buying options where the underlying stock has very little movement:
This happens a lot with options trading simply because of the trader having some familiarity with the stock and then is looking to take advantage of its movements in the options markets. For example, we had a student come to us who was in retirement and held a basket of solid blue-chip stocks but wanted to generate income from them without having to sell his outright stock holdings.
Example 1: F (FORD)
This is a classic case of tieing up investment margin waiting a long time for an options trade to generate profits when the underlying stock barely moves.
As you can see in the images below with purchasing out of the money options in your favorite stock which has low volatility will see your margin just sit and do nothing for a very long time. The likelihood of this particular stock in this particular option chain going to at the money ($14) is less than 26% at the current implied volatility.
2. LETTING PROFITS EVAPORATE DUE TO TIME DECAY
The rule of thumb when it comes to options trading on say monthly contracts are to close your positions 4-5 days before expiration. Why? well, the week of expiration you will have major time decay come in and your profits even though you're at the money or just shy of it will see a major decline.
Example 2. Understanding Theta
Since theta (or time) is a factor that looks at an option’s price relative to days to expiration, let’s take a step back and review what makes up an option’s price: extrinsic and intrinsic value. Or put simply, intrinsic value + extrinsic value = option premium (or option price).
Time decay is how much the extrinsic value or time value (and therefore total option value) decreases with the passage of one day. If time passes and all other factors are held constant, how much extrinsic value will an option lose?
If you buy (are long) options, a decrease in time (theta decay) is a negative for you, as it will cause your position to lose value. This is because there is less time until expiration, and therefore less extrinsic value in the option’s premium, causing the option to trade at a lower price than what you originally paid for it.
HOW DOES TIME DECAY AFFECT LONG AND SHORT OPTIONS?
If an option has a theta value of -0.10, it means the current price of the option will decrease in value by $0.10 for every day that passes (all else equal). For instance, if five days pass, the position will lose five times the theta value for a total loss of $0.50 of extrinsic value. This is assuming the theta value of the option does not change, but it is important to note that theta is a non-linear value and does not decay at the same rate each day.
BUYING AN OUT OF THE MONEY OPTION
An option position with a negative theta value means you are long the position. As time passes, if the stock price and implied volatility level do not change from when you initially bought the position, you will eventually lose the entire amount you purchased the option for, should the extrinsic value of the option go to $0.00. At that point, the option expires worthless, and you would lose what you paid for the position. If you were to buy an option in the money (ITM), the only value at expiration would be intrinsic (which is the difference between the strike price and the stock price).
SELLING AN OUT OF THE MONEY OPTION
An option position with a positive theta value of 0.10 means you are short the position, and that the value will increase $0.10 for every one day that passes (all else equal). This generally means you sold the option, and the option loses $0.10 of value per day in theta decay, all other factors unchanged. This can result in profit if you buy it back at a lower price than what you paid.
It is important to understand that every option has an owner and a seller. If you sell a put, you will show a positive theta value of a certain amount, while the buyer of that same put will show the same theta value, but negative. The option will lose extrinsic value as its days until expiration goes to zero. The seller of the option will profit from this passage of time, while the owner of the put will lose value (all other factors kept constant).
If you buy an option, you will have a negative theta value, meaning the option you own will lose value each day. If you sell an option, you will have a positive theta value making the options you sold cheaper to buy back as time passes, should the stock price and implied volatility level remain constant.
Selling options with high implied volatility increase the amount of money we can profit from decreasing time value since there is more extrinsic value in the option’s price.
When you sell premium (short options), your position gets stronger with the passage of time. If the strike price is OTM through expiration, the trade will reach 100% profit.
When you buy premium (long options), your position gets weaker with the passage of time. You will need the stock price to move in your favor to create more value or have an expansion in implied volatility. That would increase the extrinsic value, which increases the option price.
WHAT SHOULD YOU DO WHEN STARTING OUT TRADING OPTIONS
1. Find high beta stocks and ETF's (we trade say 10 stocks year round which offers this and always assessing their volatility to keep in on our trading screens.)
2. Make sure those high beta stocks are optionable (meaning you can trade options on that stock)
3. If they offer options the better. Most of the names we trade offer options already.
4. Make sure the underlying stock trades at least 5million shares daily in volume because you need movement and penny stocks or thinly traded stocks should be avoided
5. Learn the greeks. If you don't know what delta is or theta then you will lose over the long term.
If any of the jargon above sounds foreign but you want to learn options trading because you heard it helps build smaller trading accounts and offers better returns over holding physical shares, I encourage you to sign-up to our free Friday webinar. One of our students will discuss how he made 20K in February swing trading options part-time and will cover the greeks and what he looks for in trading setups.
Free Webinar Registration: HOW I MADE 20K IN FEBRUARY TRADING PART-TIME WHILE MAINTAING MY CAREER.