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Learn How to Buy Options To Avoid Time Decay Crush & Increase Your Chances for Profit
1. Section Title
HOW TO BUY OPTIONS WITHOUT THE FEAR
OF GETTING CRUSHED IN TIME DECAY AND
VOLATILITY
By Joshua Belanger
www.OptionSIZZLE.com
2. The risk of loss trading futures, options, currencies and other leveraged
transaction products can be substantial. Therefore only "risk capital" should be
used. Futures, options, cash currencies and other leveraged transaction
products are not suitable investments for everyone. The valuation of futures,
options, cash currences and other leveraged transaction products may
fluctuate and as a result you may lose more than the amount originally
invested and may also have to pay more later. Consider your financial
condition before deciding to invest or trade. All examples are hypothetical and
should be used for educational purposes only. Although every attempt has
been made to assure accuracy, we do not give any express or implied warranty
to accuracy. We do not accept any liability for error or omission. Examples are
provided for illustrative purposes only and should not be construed as
investment or trading advice.
3. Open 4,160.03 High 4,160.96 Low 4,131.79
For those in
attendance, how many
of you trade equity
options?
4. For those who
answered yes, how
many of you are just
buying basic puts or
calls for directional
plays?
5. How many of you feel that you're having this
problem when buying option premium?
-Not buying the right strike price
-Buying too much time
-Not buying enough time
6. The stock moves in the
direction you
anticipated...but you still
end up losing money
Does that sound
familiar?
7. What if I told you that we could fix that.
That every time you were right on your
directional opinion... you'd end up
making money on virtually every trade.
I'm not joking...It's not a magic or a secret
strategy...It boils down to understanding how
options work.
8. Joshua Belanger, Founder of OptionSIZZLE
-Started my career as a runner on the Chicago Mercantile Exchange
-Moved on to work at premier brokerage firms and trading desks
-Managed money privately for clients
-Founded OptionSIZZLE in 2008.
Was one of the first people on the web highlighting unusual options activity. Which caught the eye of
Bloomberg, BusinessWeek, the New York Post, Reuters, Dow Jones Newswire, Yahoo Finance and
the Wall Street Journal.
9. Before we get into it...it's important we
run down some key terms and the basics.
10. When you're buying an option, you are
not just trading direction.
You can still end up losing money if
you buy calls when the stock price
rises (or lose money from buying puts
if the stock price drops)
11. The movement of the stock price is just
ONE component of how options are priced.
You also have to take into account the
option strike price selected, the time to
expiration and the implied volatility.
When it's all said and done, the option
pricing model is simply a probability model.
12. Whenever You buy an option you are also long
option volatility (AKA implied volatility)
In addition, time decay is working against you.
The reason why most traders lose money on long
options (if they got the direction right) is that they
either got the timing wrong, misjudged the
implied volatility or even both.
13. An option is composed of intrinsic value and extrinsic
value.
At expiration...All options finish in the money or expire
worthless.
Intrinsic value is what the option would be worth if today
was hypothetically expiration.
Extrinsic value is the time value and volatility component
(the probability element of options).
14. Facebook on April 1, 2014 closed at $62.62 We are looking at options that expire on 4/4/14
The $61 calls (ITM) were priced at $2.01
Intrinsic Value of $1.62 and Extrinsic Value of $0.39
The $62.50 (ATM) were priced at $1.04
Intrinsic Value of $0.12 and Extrinsic Value of $0.92
In this example, the options were 3 days from expiration, notice how quickly the extrinsic value will
get sucked out of the $62.50 calls if the stock price sticks around that price.
15. Only ITM options have
intrinsic value.
ATM and OTM options only
have extrinsic value.
At expiration we are left with
the intrinsic value
16. The deeper ITM an option is...the more it will move along with the stock price
The stock moved from $60 to $61 from the following day. The option price of the call
went from $10.15 to $11.10
17. ATM and OTM options also move along with the stock...but implied volatility and time
decay play a much bigger role.
The stock moved from $60 to $61 from the following day. The option price of the call
went from $1.03 to $1.27
18. You might be thinking that's pretty good. However, we are assuming that volatility
remained constant (which it never does). What if it dropped five points instead?
The stock moved from $60 to $61 from the following day. The option price of the call
went from $1.03 to $0.97...when implied volatility dropped from 40% to 35%
19. When you trade ATM or OTM options
that are further out in time, you're
making a bet that volatility stays level or
increases. In the last example, the stock
price moved in our favor, but the drop
in volatility and time decay had a bigger
effect.
20. Symbol Price Change Volume
$64 $215 $112 $22.4
Most directional traders focus on technical analysis and price
levels...they aren't sophisticated enough to predict the direction of
implied volatility.
21. With near term options, The wost enemy of ATM and OTM options when buying premium is Time
Decay (Theta)
With longer term options, The worst enemy of ATM and OTM options when buying premium is
Implied Volatility (Vega)
Of course, Implied Volatility rising can also be your best friend...but then again, do you really have an
opinion on volatility or are you hoping to get lucky.
23. Volatility Factor
Often times implied volatility will get elevated ahead of an announcement...we see it with
pending FDA releases and earnings. Basically, anything that causes uncertainty...which has the
potential to move the stock price big in either direction.
Once that uncertainty disappears...volatility gets crushed.
Implied Volatility can also get elevated from Supply & Demand factors. This can occur from
unusual options activity.
24. If you're going to be trading
options to make directional
bets, you want to reduce the
role that time decay and
implied volatility play.
26. As we've discussed, the biggest issue
premium buyers have is that they either
getting the time or volatility factor
wrong.
But there's ways around this...ways that
will reduce the role of time decay and
exposure to volatility.
27. 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 stock substitute with a
built in stop.
The benefit of this approach is that there
isn't a whole lot of extrinsic value in the
option premium. In fact, If the stock
doesn't move much...you won't get killed
in time decay.
28. What time frame should you select when
buying options?
Well, this really depends on your opinion
on where you think the stock will go and
by when.
The beauty behind selecting deep ITM
options is that we don't have to worry
about all that extrinsic value getting
sucked out of the premium.
I'll show you some live examples in a
little bit...
29. The second idea is to buy spreads. Also known
as vertical or debit spreads.
The beauty behind spreads is that they bring
down the cost and give you a better break-
even point. The only downside is that your
profit potential is capped.
By buying an ITM option and selling an ATM or
OTM option against it, you are reducing the
effect of time decay and volatility.
It's another way to play for a directional
move...without worrying about getting the time
and volatility aspect correct.
30. Facebook, options expiring in 31 days, stock price at
$62.62 on April 1, 2014
72 delta calls: $57.50 strike, priced at $7.10
25 delta calls: $71 strike, priced at $1.41
What's the intrinsic and extrinsic value of these
options?
31. Facebook, options expiring in 31 days, stock price at $62.62 on April 1, 2014
72 delta calls: $57.50 strike, priced at $7.10
25 delta calls: $71 strike, priced at $1.41
If you bought the spread, it would cost $5.69, In
addition, the intrinsic value would still be $5.12.
However, your extrinsic value would decrease to $0.57
compared to $1.98 if you just bought the call outright.
Your break-even point has gotten better too. From
$64.60 to $63.19. By selling the $71 call, we've reduced
our exposure to time decay and implied volatility.