|
Trader's Tip
About market volatility and directions: I have never seen a ball bouncing only one way.
- David Rozen | |
Quotes & Charts
Quote Search:
Market Specific Links:
Indices/Minis
Grains
Currencies/Forex
Financials
Food/Fiber/Softs
Metals
Energy
Meats
|
Special Message from Our Author
COMPLIMENTARY Booklet: Smart Trading Techniques
Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now! | |
Today's Featured Article
Not so long ago, trading options was almost solely a playing field for large companies hedging their risk against unpredictable market moves. Besides such "heavy players", the option world consisted of some smaller speculators who used option-buying strategies to speculate. Most speculators bought options with a "lottery mentality", that is the willingness to participate in a game, in which the probability to lose is much higher than the probability to win, and yet each loss is fairly small while winners, however far and apart, have the potential to bring windfall profits.
With the upsurge of Internet use, the ability to trade brought an expansion in the numbers of option traders, and the ability to have access to quality information, brought many options traders to explore and examine other modalities of trading. Many option buyers who were exhausted by watching most of their options premiums dissipate and finally expire worthless, turned their attention to the other side of the coin, option-selling strategies. They chose to collect premium instead of paying premium.
It is widely agreed by most option traders that 75%-80% of certain groups of options will expire worthless. These are typically "out-of-the-money" options; options with strike prices ranging 8%-15% away from the current level of the underlying market, which are typically trading 60 to 90 days from expiration. This is a very important point. Lets say that again using a different angle: Many traders agree, that historically, any given market, will, 75% or 80% of the time, move less than 8%-15% during a period of 60-90 days.
Now, if statistics are on your side, what remains is to manage and limit your risk in those cases in which an underlying market decides to ignore historical data and move over 15% in a short period of time. Creating options credit spreads (see "Delta Neutral -- Trading without predicting market direction"; FutureSource, 2006) or calendar spreads
(see "Who is afraid of a calendar spread", FutureSource, 2006) is one way to limit your risk in such scenarios. However, while my other papers focused on such selling strategies and gave an overview of actual adjusting procedures, in this paper, I will revisit one of the basic theoretical rudiments of option selling and of option trading in general: Time value or Time decay.
Any and all options have an expiration date. The finite nature of options can be easily observed by taking any option and comparing its value at different points in time. Choose any option and compare its value at three months, two months and one month prior to expiration. You will immediately notice that whether the option is "out-of-the-money" or "in-the-money", barring a large move in the options' direction, its value decreases as time passes. This is because every option is comprised of two basic values. Those are "Intrinsic Value" and "Extrinsic Value".
Intrinsic value is determined by how much the option is "in-the-money", a call option at a strike price 60 has an intrinsic value of 1.0 if the underlying market is trading at 61. The intrinsic value of that option is 5.0 if the underlying market is at 65, 8.0 if the market is at 68 and so on. A put option at the 60 strike price on the same market, has an intrinsic value of 1.0 if the market is at 59, 5.0 if the market is at 55, and so on.
Extrinsic value on the other hand, is determined mainly by the time left to expiration (time value), the volatility of the underlying market, and the distance of the market from the option's strike price.
| |
|
A Word from a Fast Break Sponsor
Advertise With Us
Think you can trade? Prove it.
Sign up for Complimentary Demo Account from Arc Capital Management and enter the Tournament of Champions, forex edition. Arc Capital Management is an Independent Introducing Broker providing institutional clients, professional traders and financial investors with the means to help you achieve your goals. Go Here for details. | |
|
The Extrinsic Value of an option is greatly influenced by Volatility.
This is because in flat markets (low volatility), the probability of the underlying market reaching a strike price far out-of- the-money is relatively small. In times of large movement in the market (high volatility), the probability of the underlying to reach the same strike price is greater. Somewhat paradoxically, however, high volatility is one reason why experienced and smart options sellers often do better then their peers (directional traders) and show better results in a highly volatile environment. In such highly volatile environments, options values (premiums) are often extremely inflated. Many options are overvalued, which allows smart traders to sell options farther
out-of-the-money and collect premiums well above the hypothetical value of the options.
Other than volatility, the value of an out-of-the-money option is made out of time. Time value is inherent in all options. Prior to expiration, every option has time value. All things being equal, the more time an option has until expiration, the more time value it has. An option with 90 days to expiration has greater time value than an option with 60 days to expiration that will, in turn, have more time value then an option with 30 days to expiration. An option at expiration date, which is out-of-the-money, has no time value at all and therefore, expires worthless.
Out-of-the-money options have no intrinsic value at all (Volatility aside, the value of these options is comprised only of their time value). Since out-of-the-money options have nothing but Time Value, every day that goes by, can reduce the time value of the option. This is important to understand. All things the same, regardless of which direction the underlying market moves, an option loses time value each and every day
. Time never stops, and time decay never stops either. That includes trading days, weekends, and holidays. Options are always and forever subject to the eroding effects of time decay. In-the-money options also experience time decay, it is much more evident, however, when examining an out-of-the-money option since the erosion in the overall value can be staggering. So much so, that it is safe to say: "When you sell an out-of-the-money option, you are essentially selling time"! And when dealing with time, it feels great having it on your side.
Other than risk management, time decay might very well be the single most important factor to understand when trading options. This is because unlike anything else in the world of trading, time is 100% predictable!
Fundamental traders try to predict market moves by putting their attention on local and global events such as geopolitical tensions, earning reports predictions, inflationary indexes, weather conditions and more. Technical traders attempt to predict market direction by looking at chart patterns. There are many systems out there, some are good, and some are not. While both of those approaches may work for some traders, some of the time, I strongly believe, and suggest, that it is extremely difficult to consistently predict market direction
. Selling options, and focusing on time decay, proposes a new paradigm of trading, a paradigm which to some extent is independent of market direction and one which benefits from the one thing we all know too well, time passes, time simply moves on.
One aspect of time-decay, which is often misunderstood and mismanaged, is the rate of time decay. "Theta"
is the Greek symbol used to measure the relationship between time value and the time remaining to expiration. The rate an option losses time value is not consistent throughout its lifetime. Similar to most decaying processes, as the option nears its expiration date, the rate of decay increases. In fact, during the last month prior to expiration there is a significant increase in the rate of time decay and in the last days prior to its expiration, an option may lose or gain value almost in tandem with the moves of the underlying market. It is easy to see why.
If a call option is at-the-money
(a strike price at the same level of the underlying market; strike price of 60 with an underlying trading at 60) and has 90 days to expiration, if the market moves 10 points lower, the option will lose value, but since the market has 90 days to potentially move back up, the call option would only lose a fraction of the 10 points. An option with one day to expiration will lose a much greater portion of the 10 points, since it does not have the luxury of time to regain its value. In the same manner, an option with 60 days to expiration will lose more value in an adverse underlying move than an option with 90 days, and an option with 30 days will lose value faster than an option with
60 days, and so on and on.
| |
The change in the rate of time decay leads many options sellers to write (sell) options with an expiration date of 30 days or less. It is a pitfall you should avoid. There are several reasons I do not like to sell options in the last 30 days prior to expiration.- Though the rate of time decay indeed increases as the option nears expiration, there is still significant time erosion in options that are trading 90 and 60 days to expiration. You could clearly observe this point by taking any option at all and looking at the same strike price in different months.
-
When selling an option with 30 days to expiration, traders usually collect very little premium if they wish to sell a statistically significant distance from the money. As a result, traders end up being "married to the trade" for good or for bad. Collecting very little premium might force the seller to stay with the trade until expiration or very near it. Flexibility to adjust and manage the risk is taken away.
-
If sellers wish to collect more premium while selling "one month out", they are often tempted to sell a strike price that is fairly near the money. By doing so they are not only subjecting themselves to greater risk should market volatility increase, they are also giving away, to a large extent, the main benefit of options writing -- selling time rather than trading directionally. It is true, in selling one month out, time decay is faster, but one also becomes subjected to the directional whims and moods of the market.
-
The fourth incentive to selling options 60 and 90 days out in time rather than 30 days is the margin requirements, or the relative return on your investment. As an option nears its expiration day, the margin required to hold it increases. Here is why. At expiration, one of two things will happen to an option. It will expire worthless if it is out-of-the-money or it will completely converge with the underlying market. If an option expires in the money (and is not cash settled), it becomes one with the underlying market, a futures contract, any move of the underlying will be manifested in identical gain or loss to your position.
Because options converge with the underlying at expiration (if they are in-the-money), they are perceived as more dangerous. As a result, the margin requirement, or the collateral requirement, increases as the options near expiration. This is true for options that are out-of-the-money as well. This is so because the potential for the underlying market to make a sudden large move always exists.
A similar spread, at a similar distance from the money (from where the underlying is trading) will require more collateral when it is sold 30 days out rather than 90 days out. In other words, in order to collect $1,500 in premium, you will have to tie approximately $2,000 if you sell 90 days out, and approximately $3,500 if you sell 30 days out.
A quick comparison between selling 30 days out in time vs. 90 days out in time will demonstrate that:
A) You collect smaller premiums when you sell only 30 days out.
B) You are closer to the money and hence are subject to greater risk when you sell only 30 days out.
C) Your margin requirement is greater, thus your leverage (the return on your dollar) is smaller when you sell only 30 days out.
Considering those three aspects, I think your preference should be selling 90 days out rather than 30 days only.
Time value and time decay could provide enough theoretical and practical discussions to fill many books. In this short article, I wanted to touch on the basics of the issue and to review the importance of time value and time decay when trading options. To conclude, I want to point out an interesting observation. When trading any underlying a trader needs to be 100% correct about the direction of the market. Options buyers have to be 110% correct about the direction of the market. Why 110%? Because not only do they need the market to go to the strike price they paid for, but they need the market to surpass that strike price by at least the premium they paid -- before seeing any profit on
expiration. To top all that, option buyers have to be correct about the direction, in a very certain, defined, and limited amount of time. Option buyers put themselves in a race against the clock. While sometimes it might be a good idea to buy options as a part of an overall strategy or to protect a specific position, I do strongly believe that when trading options, you should put time on your side. If you treat your trading as a marathon and not as a sprint, options selling should be a part of your portfolio.
| |
About the Author
David Rozen is a senior account executive with Trader's Edge. He is fluent in various futures and options trading strategies. David's favored method of trading is non-directional (delta-neutral) trading, utilizing pre-determined, limited risk structures. He trades options on several complexes, including the Stock Indexes (S&P 500), the Interest Complex (30 yr. Bonds), Metals, Grains and Currencies.
David served as a commander in a combat unit of the Israeli Defense Forces (IDF). His service and commanding experience play a great part in his ability to evaluate situations and make decisions under pressure in real time. After his service, David continued to earn his degree in Behavioral Science from Haifa University, Israel.
Three years after joining Traders Edge, David joined Gene Ratti and Bill Chieco to create a partnership within Trader's Edge. David is fluent in both English and Hebrew and serves clients across the United States as well as England and Israel. David's professionalism and passion for trading as well as his dedication to providing the utmost in service to his clients have swiftly made him a rising star at Trader's Edge. David contributes to various on line services including Fast Break, FutureSource, and "Optionsscholar.com". David resides in Morris County, NJ with his wife and two children. | |
Special Message from Our Author
COMPLIMENTARY Booklet: Smart Trading Techniques
Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now! | |
|
