If you’re just getting started with trading options, you may run into a financial adviser or broker telling you stay away from them.
You’ll hear that options are “too risky!” (which we’ve already proven is untrue) or “too complicated!” (also untrue)…
Or this …
“Options are fixed-time investments that expire on a specific date!”
That is true. But that “fixed time” feature doesn’t have to work against you. Quite the opposite. It gives you the flexibility to focus your trade the way you want to – a flexibility you don’t have with a straight long or short equity position. But you need to know how to use it.
If there’s one thing you need to know about options, it’s how to handle this “fixed time” aspect of trading them. Picking the right expiration date can make the difference between a small 15% gain and a huge 300% winner.
So today I want to spend some time to help you get this all down pat, so all your broker rep’s will need to do is provide you the most efficient means to execute your orders. (Heck, if you are using an online platform, you may never have to talk to them at all.)
And then look out for my email next week, when I’ll show you how to focus your trade by picking the right expiration, as well as my personal favorite timeframe for trades.
Let’s jump right in.
Note from Tom: I am primarily going to discuss dealing with time on straight options trades, meaning buying call or put options. I will, however, follow up with an observation about the loophole trade and a benefit of this type trade over a straight option trade.
How Expiration Dates Work
When you buy an option to open (“open” means to enter or start the trade), you then have the right, but are not obligated, to either buy stock from someone – a call – or sell/put stock to someone – a put.
The option has a strike price as well as an expiration date, both of which you choose.
You have some amount of control as to what expiration date you purchase, based on what expiration dates are available to you.
On optionable stocks there will always be expirations for the current month and the next month out. For example, here we are in August. There will be August AND September expirations. Then options fall into whatever option cycle they are a part of.
The standard expiration for each month is considered the 3rd Friday of each month. There are weekly options on some of the more liquid stocks.
|The Three Option Cycles:
JAJO: January, April, July, October
FMAN: February, May, August, November
MJSD: March, June, September, December
Reminder: The current month plus the next month will likely always be available to buy and sell. If you are looking at an option chain for a stock on the FMAN cycle and we are in August, you will likely see August and September options listed, but none for October.
There may be some options for out in January of next year and maybe even January of the year after that. What in the heck are those? Those are LEAPS, which stand for Long-term Equity AnticiPation Securities. They are pretty much the farthest-out option expiration available, out as much as three years.
How Time Value Works to Inform Pricing
Let’s assume you’re buying an option.
The amount you pay to buy that option is called the premium. There is a whole mathematical equation/formula used to determine the premium on any given option. It’s called the Black-Scholes formula.
Don’t worry too much about it right now.
Just understand that there are two types of value: extrinsic and intrinsic. The part of the cost paid for time value is known as extrinsic value. (I’ll return to intrinsic value later.) The more time until expiration, the more time value you will pay for, because more could happen to the price or the market in that time. So again, the farther-out options are going to cost more.
Back to this fixed time investment aspect to options.
Every day that goes by in the markets gets you one day closer to expiration; one more day that time has gone by. Time WILL go by – nothing you can do about that – and that time value will come out of the premium price of the option.
That’s why it’s important to get the timing right.
The amount of money time represents is all calculated by that pricing formula and is represented in the option by the Theta. So, whatever that theta amount is, it will come out of the option price daily.
The question is do you buy an option with an expiration that’s 1-3 years out… or do you buy one with a shorter time until expiration?
That depends on how long you expect it will take for the stock to accomplish its price move.
|More on the Option Greeks
The components of the price of an option are known by Greek terms:
- Delta: Measures the change in the price of an option relative to the change in price of the underlying
- Gamma: Measures the change in the Delta of an option relative to the change in price of the underlying
- Theta: Measures the change in price of an option with respect to a change in its time to expiration
- Vega: Measures the change in the price of an option relative to each one-point change in implied volatility
These are all calculated dynamically, and the end result is the premium price you see on your options chain screens.
The goal is for the stock to move in your direction so the Delta value and the Gamma values offset that Theta decay and your option becomes a higher value.
This gets a little complex so for now let’s just focus on time value, or Theta. (If you’re especially interested in this, you can read up on option Greeks in “The Index Trading Course,” the book I co-wrote with George Fontanills in 2006.)
When to Choose a Longer Timeframe
If you think it will take a couple of years for the stock to get going, then consider buying the LEAPS on it, as it will be cheaper than buying the stock outright.
If the stock goes up in price, the option should as well. It will do so on both the longer and shorter term options, but it will move up faster on the shorter-term options because of the effects delta and gamma have on it.
The farther out in time you go, the slower the option will increase, compared to a shorter-term option. That makes sense if you think of it like this: You are taking on more risk by having a shorter timeframe for the option to go up in value, so your reward opportunity reflects that.
On the longer-term option, the time value will decay more slowly. That is one benefit of the LEAP. You can see the difference in the option chain image of the LEAP on MasterCard Inc. (NYSE:MA) below compared to its shorter-term option.
LEAPS option on MasterCard Inc. (NYSE:MA)
Click to Enlarge
The one option Greek or component that works against
all options traders is time or Theta decay. As stated, Theta isn’t hurting you as much on a LEAP compared to shorter-term options.
Theta in the LEAP is much less than that in the September expiration – the one that expires next month.
Next-month option on MasterCard Inc. (NYSE:MA)
Click to Enlarge
But here’s the tradeoff…
When to Choose a Shorter Timeframe
While the Theta works against you if you’re a shorter-term option trader, the Delta and Gamma work for you, especially the more the option is In the Money (ITM) or has what’s known as intrinsic value.
Let’s take a second to look at that.
For a call option, when the stock price is higher than the strike price of the option you own, that is an In-the-Money (ITM) call. The right to buy the stock at a lower price (strike price) than the current market price has a built-in value and that is also priced into the premium.
If you have an ITM option and a far out expiration, those are usually the more expensive options, because there’s intrinsic value AND extrinsic value.
There’s an even better way…
Be back with you next week.