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The Ugly Truth About Buying Options
by Joshua Belanger
Now, if youve read Why You Should Avoid Trading Options All
Together, youll know that Im a huge fan of selling option premium
(responsibly). In fact, Im constantly surveying the market for
unusual options activity looking for the best trading candidates
(using my SIZZLE Method).
Often times, premiums get jacked up after these monster-sized
institutional orders hit the tape thats when Ill look to be a
seller of high premium (or possibly construct a spread, to slow
down the role of time decay and reduce the effect of implied
volatility).
I just feel that risk vs. reward it makes the most sense.
However, that doesnt mean you should never buy options, in fact,
being a premium buyer has its own unique benefits. Namely, the
opportunity to have greater returns if something extraordinary
happens to the stock price of a company.
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Of course, it can be very tricky, that is, selecting the right
option strike price and expiration period. Hence, most option
buyers end up failing falling flat on their face and end up losing
money on their trades.
Are you losing money because youre buying too much time or not
enough?
Are you seeing the stock price move in the direction you
predicted, but still end up losing on the trade?
Look, there is a learning curve involved with trading options,
and if you answered yes to any of these questions, its OK. No one
was born with the knowledge to trade options; they all learned from
studying and trading the markets.
For many, that means learning from mistakes (AKA paying your
tuition to the market in the form of trading losses).
Besides, I wouldnt be honest if I told you that I havent paid my
fair share of tuition in the past. However, Id like to think Ive
graduatedand Im ready to share with you a couple of things Ive
learned about buying options outright.
1. When you buy options, you are not just trading direction.
Many new investors think that if they buy a call and the stock
price goes up, theyll make moneyor if they buy a put, and the stock
price drops, theyll make money. WRONG!
2. There are several components that go into pricing an option.
Most importantly, the price movements of the stock, the option
strike price selected, the time to expiration and the implied
volatility. The option pricing model is simply a probability
model.
3. An option is composed of intrinsic value and extrinsic
value.
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Example:
FACEBOOK on April 1, 2014 closed at 62.62
The mid-price for the 4/ 4/14 (expiration) 61 call is $2.01
Intrinsic value is what the option would be worth if today was
hypothetically expiration.
In this case, the intrinsic value is $1.62.
The extrinsic value is the time value and volatility
component.
In this case, its $2.01 minus $1.62 or $0.39.
The mid-price for the 4/4/14 (expiration) $62.5 call is
$1.04
The intrinsic value $0.12 and the extrinsic value is $0.92. As
you can see, time value and volatility consist of most of the value
in this option.
Remember, at expiration, all options are left with their
intrinsic value.
Its just another way of saying that they will either expire in
the money or expire worthless.
In this case, if the stock settled at $62.62, these options
would lose 88% of their current value. With only three days to
expiration, you
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can see how quickly the time value and volatility get sucked out
of these options.
4. Only in-the-money options have intrinsic value. With that
said, at-the-money and out-of-the-money options have extrinsic
value only. The deeper in-the-money an option is, the more the
option price will move along with the underlying stock.
An at-the-money option will move with the stock, however, it has
to overcome the time value (that is accelerating)the option may
gain value if option volatility risesor the option may lose value
if option volatility drops.
5. Near term option trading is referred to as trading gamma and
farther out (in time) option trading is referred to as trading
vega. What does that mean? It means if you select near term options
to buy, you are making more of a bet on the directional move of the
stock.
If you select farther out options, you are not only making a bet
on the direction of the stock, but you are also betting that the
option volatility rises. (The option Greek Vega measures the
sensitivity to volatility).
Now, there is nothing wrong with trading longer term options
that only have extrinsic value, however, most directional traders
arent really sophisticated enough to have an opinion on whether or
not option volatility is cheap or expensive.
In fact, this is where a lot of the mistakes occur. If you are
buying at-the-money or out-of-the-money options, you need the
directional move to overcome the time decay and you need option
volatility to rise.
Whenever you buy an option outright, youre always long vega (or
option volatility).
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A perfect example would be after an earnings announcementin
almost all cases, option volatility gets crushed, sometimes so
muchthat it overcomes the gain made from the stock moving in your
direction, which ends up causing the option to be a loser.
6. Time value always accelerates as we approach expiration.
Further, option volatility is a wild card. In fact, it can be
driven by a number of different factors.
For example:
Uncertainty- Often times option volatility will be elevated in
biopharmaceutical companies if they have a pending drug approval
announcement. The market doesnt know if the news will be positive
or negativehowever, they feel that it will cause the stock price to
have a monster-sized move.
A recent case is Mannkind (MNKD). On April 1, 2014, the stock
was trading at around $4 per share. The $4 calls and puts
(straddle), expiring on 4/4/14 were pricing a +/- $2.40 move.
After the close, their diabetes drug got FDA approval and the
stock price gained over 100% in the after-hours.
The following trading day, option volatility got crushed because
the uncertainty disappeared.
Supply & Demand- This usually occurs from unusual options
activity. For example, on April 1, 2014, Gastar Exploration Inc
(GST) saw 7.5x usual options volume.
This demand for options caused the implied volatility in the
options to have a huge spike.
In fact, the implied volatility had a change of over 21.2%.
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On the flip side, if large option sellers come into the market,
the value of the option premium decreases and implied volatility
declines.
7. The higher the implied volatility is, the more expensive an
option is. The lower the implied volatility is, the cheaper an
option is.
8. Delta is the Option Greek that tells us how much we expect
the option to move in relation to the stock price movement. For
example, if we are long a 50 delta call option, and the stock moves
up $1, we can expect to make $0.50 on our option. Keep in mind, we
will lose some money from the time decay.
Also, we will make money if implied volatility rises or we will
lose money if implied volatility declines.
Ultimately, if you are going to be using options to make
directional bets, you want to be trading deltas. Ideally, youd like
the time value and volatility component to be reduced as much as
possible.
To get a better understanding, check out these options in
FACEBOOK (FB).
FACEBOOK: stock price on April 1, 2014, $62.62
Expiration in 3 days
75 Delta Options
Intrinsic Value: $1.62 Extrinsic Value: $0.39
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53 Delta Options
Intrinsic Value: $0.12 Extrinsic Value: $0.92
23 Delta Options
Intrinsic Value: $0 Extrinsic Value: $0.31
Expiration in 31 days
72 Delta Options
Intrinsic Value: $5.12 Extrinsic Value: $1.98
50 Delta Options
Intrinsic Value: $0 Extrinsic Value: $3.93
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25 Delta Options
Intrinsic Value: $0 Extrinsic Value: $1.41
Expiration in 81 days
75 Delta Options
Intrinsic Value: $7.26 Extrinsic Value: $2.82
48 Delta Options
Intrinsic Value: $0 Extrinsic Value: $4.58
23 Delta Options
Intrinsic Value: $0 Extrinsic Value: $1.68
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As you can see, the greater the delta, the more intrinsic value
the option has. In addition, the closer to expiration, the less
extrinsic value for higher delta options.
Again, if youre buying options for a directional move, you want
to try to reduce the time and volatility component that goes into
its pricing.
9. When implied volatility rises, its like adding more time on
the option. For example, when implied volatility rises, the options
are worth morein a sense, its like time was added to the
option.
On the flip side, when implied volatility drops, its like time
was taken out of the option. When implied volatility drops, the
option becomes worth less.
Putting it all together
Now, one of the issues that premium buyers have is that they
dont gauge the timing and implied volatility of the option
correctly. After all, their thought process is, if I buy a call and
the stock rises, my options should increase in value.
As weve learned, if you buy an at-the-money option (or an
out-of-the money option), the move in the stock price needs to
overcome what youll lose from the time decay and potentially a drop
in implied volatility.
If your goal is for a directional play only, you want to try
limit the time and volatility aspect. Forgive me if Im sounding
like a broken recordbut I cant stress this point enough.
How do we do this? Well, there are two ways.
First, buy options with high intrinsic value. For example, buy
an option with a delta of 70-75. In many ways this could be viewed
as a
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stock substitute. However, youve still got a great deal of
leverage and a built in stop.
Often times, equity traders will set stops for themselves, when
you buy an option, youve already defined your risk.
The benefit of this approach is that there isnt much extrinsic
value in the option. With that said, if the stock doesnt move much,
you wont get killed in time decay.
What time frame should you buy?
Well, that should be based on your opinion on where you think
the stock will go.
Is it a day trade, a swing trade or a longer term position?
By answering this question, youll have a better clue on which
option contract to select. For example, weekly options are best for
day trades, for swing trades you can use options that expire in
14-30 days. Of course, for longer term swing trades you can go out
45 days to 90 days.
Why not longer?
Well, because these options dont have a great deal of extrinsic
value, you can always roll the position, meaning close out one
contract and buy a later dated month. Now, dont get caught up in
these numbers, its really based on where you think the stock will
go and by when.
I know traders who will go out 45-65 days on swing trades and
180 days for longer term trades.
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There are no hard rules or magic time framesits really based on
your opinion.
Now, Im not saying you cant make money by buying at-the-money or
out-of-the money optionsbecause you most certainly can. However,
youll need a fast and aggressive move in the stock if youre trading
options with 30 days or less left till expiration.
If you dont see that, the time decay will melt that option
premium away.
When you go farther out in time, you are also betting on
volatility to rise. Again, for the average retail trader,
volatility is very complicated subject matter. It involves doing
analysis on historical volatility and comparing it to implied
volatility.
In addition, you have to put it into context to figure out if
volatility is cheap or expensive.
If youre buying an option because you think the stock price will
go up or down, dont you want to make things as simple as possible
for yourself?
I know I do.
Too many times traders get hung up with buying cheap options
because theyre cheap and they can buy a lot of them. They feel that
they are getting a better deal than buying the more expensive
in-the-money options.
Now, the reason why I showed you all those different FACEBOOK
options is that I wanted to show you that expensive options are
actually cheaper than at-the-money and out-of-the money
options.
The chances of making money on an out-of-the money option are
not favorable. In fact, the odds are actually horrible.
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Besides, your goal is to make money on the trade, not to load up
on as many option contracts as you can.
Second, you can buy a spread. A long spread is simply a long
call (or put) against a short call (or put). Because the option you
bought is more expensive than the one you sold, the trade is done
for a debit.
Why would we do this?
Well, by selling an option against our long, we are reducing the
effect of time decay and volatility.
In essence, its another way to play for a directional move. Not
only that, but spreads also reduce your overall cost.
Example:
FACEBOOK (FB) options expiring in 31 days, stock price on April
1, 2014 is $62.62
72 Delta calls: $57.50 strike, priced at $7.10 (with an
intrinsic value of $5.12 and extrinsic value $1.98)
25 Delta calls, $71 strike, priced at $1.41 (with $0 intrinsic
value and $1.41 of extrinsic value)
If you bought this spread, it would cost $5.69. In addition, the
intrinsic value would still be $5.12however, youre extrinsic value
would decrease to $0.57. That means if the stock stayed at the same
price on expiration, youd only lose $0.57.
Not only that, but your break-even point has improved, when
compared to buying the outright call. You see, by selling the $71
call, weve reduced our exposure to time decay and implied
volatility.
Of course, if the stock trades north of $71 at expiration, this
spread could yield a return of over 135%not too shabby.
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At the end of the day, youve got to be right on your opinion on
whether or not the stock will trade higher or lower. What Ive done
is shown you two methods to express that opinionthat reduce the
role of time decay and effect of option volatility.
Lastly, Id like to thank you for this post. You see, I get a lot
of questions about this in emails, on Twitter, Facebook and
StockTwits. Id be lying if I said you didnt inspire me to write
this.
He who asks a question is a fool for five minutes; he who does
not ask a question remains a fool forever.
I really love that Chinese proverb; I think its so true. With
that said, dont be shy and keep the questions coming. As always, Id
love to hear your thoughts in the comments section below.
If you enjoyed what you read and you want to continue learning
more on how to to become successful in financial markets using
options, visit http://www.OptionSIZZLE.com You can also download
your FREE report that teaches you The #1 Secret On How You Can Find
Tomorrow's Best Trades Today! Joshua Belanger is the founder of
OptionSIZZLE.com and his dream is to not only create wealth,
freedom & options for himself, but for you as well.
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