One (Back-Tested) Way to Trade Time Decay

Good morning, Power Profit Traders!

The Nasdaq suffered its worst session since March on Tuesday, which stopped out a couple of my positions on Facebook (FB) and Apple (AAPL) — the latter of which is featured on today’s Power Profit Traders Watchlist, which we’ll get to shortly.

See, any trading expert who claims they don’t endure losing trades every now and then is full of hot air.

No one is infallible, and there are no guarantees in the market — all we can do in this game is try to identify repeatable patterns, utilize all the tools at our disposal to gain an edge, and make the best educated guess possible as to the underlying’s direction.

We go into every trade with a plan, with our risk managed (via contingency orders or otherwise), and our potential exits already mapped out… The rest is up to fate.

Picture your personal trading history as a single stock chart. Sure, there are going to be day-to-day fluctuations, but as long as the longer-term trend is higher, you’re in good shape.

Still bullish on the shades, btw

The important thing is to learn whatever you can from the inevitable loser, adapt your strategy if necessary, dust yourself off, and get back out there!

That said, today I want to take a look at the bearish option traders targeting AAPL, and offer up a lesson — and a trade idea — on taking advantage of time decay. And then don’t forget to catch Team Tom trading LIVE at 11 a.m. ET right here!

Apple Puts Popular After Nasdaq Nosedive

Last MONDAY, we saw a precipitous drop in stocks… This week, the sell-off went down on TUESDAY… Does that mean Buyer Beware next Wednesday?

Let’s hope not — this is one pattern I don’t want to continue.

The question now is, do we rally again or see some sustained selling this time?

Well, as I’ve mentioned in this space, my Money Calendar suggests October could be bullish for equities, if recent history is any indicator.

However, in the wake of yesterday’s nasty day for the Nasdaq, it looks like some option traders are expecting more short-term downside for Apple, which is at the top of the Unusually High Put Option Volume list, courtesy of the free Morning Report tool in the TG Suite app.

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You can see in the image above, the option contract is written as YYMMDD to indicate the expiration date, then C for Call or P for Put, followed by the Strike.

By purchasing the AAPL October $136-strike puts (which are standard monthly options expiring the third Friday of the month), the buyers expect AAPL shares to sink beneath $136 by expiration — Oct. 15, in this case.

The further the stock drops beneath that put strike before the options expire, the more the put buyer stands to gain… But in order for the contracts to move into the money (ITM), AAPL shares would have to fall into territory not explored since July.

On the flip side, if the buyers paid $1.53 for the puts (under the Price column in the Watchlist image above), that’s the most they stand to lose, should AAPL shares stay above that $136 level through options expiration.

Not only are those puts out of the money right now, but vanilla buyers (those who didn’t purchase the puts to hedge shares they own) are also staring down the barrel of time decay

Time Decay — And One Way to Trade It

Time decay is the erosion of an option’s price as expiration approaches.

See, several factors go into an option’s price, including time value. The more time a stock has to make a huge move, the better the odds the option can move into (or deeper into) the money.

So if a stock is trading at $95, a $100-strike call option expiring in three months is going to cost a lot more than a $100-strike call option expiring in three days.

But while time decay works against the option buyer, it works in favor of the option seller.

Although most traders stick to simply buying to open puts or calls, more advanced speculators take the other side of that trade — SELLING puts or calls to open.

By doing this, they’re basically drawing a line in the sand (the strike price), stating they don’t believe the shares will cross that threshold before expiration.

Put sellers want the stock to stay above the strike, and call sellers want the stock to stay below the strike.

If the sold put or call stays out of the money, the option expires worthless — bad news for the buyer, but good news for the seller, who gets to pocket that initial premium.

However, the RISK on a sold-to-open option is pretty steep… IF the trader doesn’t have a leg of protection.

That’s why I recently broke down a back-tested calendar spread.

Specifically, the strategy is selling to open the Walmart (WMT) $141-strike puts that expire next Friday, Oct. 8, to bet on a floor at that level until then.

Then simultaneously buying some options “insurance” to protect against a plunge, purchasing to open $141-strike puts that expire Friday, Oct. 29.

If WMT stays above $141 through Oct. 8:

  • The sold puts will finish out of the money (OTM) and the trader can pocket the $1.79 received at initiation.
  • The trader could then sell to close the Oct. 29 $141-strike put for a minor loss — but not a loss bigger than the profit from the shorter-term put, because the longer-term contracts would still have three weeks’ worth of time value.

And my toolbox indicates an 82% chance the WMT dead-cat bounce stays in this range over the next week, if history is any guide:

That’s all for now, but be on the lookout for another YouTube message from me soon!

Until then, get in the room and soak up another LIVE session with Tom’s Team… you never know when we’ll pull out the big-money stats and trade ideas!

Tom Gentile
America’s #1 Pattern Trader, Power Profit Trades

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