Tag: time decay

Buying Call Options - Defining Risk, Optimizing Time Value and Realizing Gains

Posted on by The INO.com Team

Options can provide an alternative approach to the traditional buy and hold strategy. Buying call options can add value to one’s portfolio via leveraging a small amount of cash while defining risk with unlimited upside potential. Simply put, buying a call option is bullish in nature as the buyer is positioning the trade with the thesis that the underlying shares will increase in value. When one buys a call option, she is buying the right to purchase shares at a specific price on a specific date in the future for a nominal price. In this scenario, the buyer thinks the shares are undervalued hence why she is willing to buy the option now to secure the right to purchase shares in the future at a higher price. If the shares approach the specific price or rise above the specific price before the expiration date, then the underlying option becomes more valuable. This more valuable option can now be sold higher than when she purchased the contact to realize gains. Regarding percent, call options can be very profitable and scaled as needed. The risk in buying call options is capped based on the amount of the option itself thus downside risk is defined, and upside potential is great. Here, I’ll discuss buying call options along with my approach, strategy and real-world outcomes.

Anatomy of Buying Calls

I rarely buy call options however in opportunistic scenarios the risk-reward is very favorable given a decent time horizon. Nominal amounts of cash can be deployed in opportunistic scenarios to capitalize on sell-offs in high-quality stocks. Buying calls can be implemented as a means to leverage cash on hand without committing to purchasing the underlying shares of the company with the end goal of capitalizing on share appreciation via the option contract. The option price is determined by two variables, time and intrinsic value. The amount of time until expiration of the contract determines the time value, the longer the contract will translate into more time value in the contract (Figure 1). Generally speaking, if the underlying stock falls in value (moving away from the strike price), then the option will decrease as a function of time value. Alternatively, if the underlying stock appreciates (moving towards the strike price), then the option will increase in value as a function of time value. As the stock moves away or towards the strike price, the underlying stock is less likely (decrease in option value) and more likely (increase in option value) to reach the strike price, respectively hence the change in option value.

Intrinsic value isn’t applicable here until the underlying security breaks through the agreed upon price (strike price) before expiration. Every penny that the stock appreciates beyond the strike price is a penny of intrinsic value that increases the value of the contract. Any increase in the stock price will result in an increase in the option value regardless. Continue reading "Buying Call Options - Defining Risk, Optimizing Time Value and Realizing Gains" →

Traders Toolbox: Learning Options Part 1 of 4

Posted on by lindsay

There are four components to an options price: underlying contract price, intrinsic value ( determined by strike price), time value (time remaining until expiration) and volatility. (A fifth element, interest rates, also can affect option prices, but for our purposes is unimportant.)

Intrinsic value refers to the amount an option is in-the-money. With Eurodollar futures at 95.55, a 95.00 call has an intrinsic value of .55. The more an option is in the money, the greater its intrinsic value. At-the-money and out-of-the-money options have no intrinsic value.

Options are referred to as "wasting" assets because their value decreases over time until it reaches zero at expiration, a process called time decay. Time value refers to the part of an option's price that reflects the time left until expiration. The more distance an option's expiration date, the greater the premium because of the uncertainty of projecting prices further into the future.

Considering two equivalent call options. With May corn futures at 232 1/4, July corn futures at 236 1/4 and 10 days left until May corn options expire, a May 230 call might cost 2 3/8 while a July 234 call costs 6 1/2, even though they are equally in-the-money.

Volatility, perhaps the most important and most widely ignored aspect of options, refers tot he range and rate of price movement of the underlying contract. The "choppier" the market, the higher the price that will be paid for this unstability in the form of higher option premiums.

Volatility usually is expressed as a percentage, and is comparable to the standard deviation of a contract. Higher volatility means higher premiums. Lower volatility means lower premiums. A trader familiar with the volatility history of a contract can gauge whether volatility at a given time is relatively high or low, and can profit from fluctuations in volatility that will in turn increase or decrease option premium.

The Black-Scholes price model, first introduced by Fischer Black and Myron Scholes in 1973, is the most popular theoretical options pricing model largely because it was the first relatively straightforward arithmetic method for determining a fair value for options.

Part 2 Will Be Posted On November 10th, 2008. So come back soon!

Option Trading – Calendar Spreads & Time Decay

Posted on by The INO.com Team

From David Riveria from Delta Neutral Trading comes a lesson on Option Trading...Calender Spreads and Time Decay. Learn more about David and his site Delta Neutral Trading.

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When traders speak of putting on calendar spreads, they normally refer to buying the further month options and selling the closer month option. While I can not argue with this, it is not best for all options.

I am going to be general in this article because prices change and I don’t want to cause confusion.

For out of the money options, you might want to consider doing the opposite. Buy the close month and sell the further month. This is because the theta is advantageous to you if you are buying the front month. The further the months are from each other, the more you have an advantage. Also, figure out the price per day of the option. Which option costs more and which is cheaper per day. You can find options that are equal distance away in strike from the futures but one option is 3 times cheaper per day than the other.

For the at the money options, the regular calendar spreads are the way to go. For strike prices that are far out of the money, the reverse calendar spread is better. One reason is the theta advantage. Another is the price per day.

So keep your eyes open for out of the money options and check their price per day and theta and compare them to different months. If you are looking at different months, make sure that the month you are thinking of selling, is the same amount of strike prices away or more from the underlying, as the one you sell. Meaning, if you buy an option that is 5 strikes away from the underlying, the one you sell, should be at least 5 strike prices away from the underlying. This is so if there is a big move, both options will be in the money at roughly the same time.

David Rivera has traded commodities and options for one of the largest cash trading firms in the world. He has written a course on futures options techniques.

You can find out more about this concept at: Delta Neutral Trading