Making Something out of Nothing
It’s amazing and so simple. Of course those are the words usually uttered after some sort of epiphany. And learning about stock options is loaded with epiphanies. Take, for instance, making money on a boring stock that moves only slightly-if at all. If a trader understands the nature of stock options, a tired old stock can make an option trader’s heart beat faster.
When learning about stock options and how they are priced, a trader learns that the premium paid for each option is composed of two elements. The first element is based upon the value of the option having some added value brought about by the current stock price of the underlying being above the strike price of the option. This added value is called intrinsic value and is normally a close correlation of the additional amount above the price strike.
The other principle pricing element is called the extrinsic value portion of the premium. Extrinsic value represents the value of time for the option to increase (call) or decrease (put) in value. The more time, the more the possibility that the option will move in the desired direction. So, normally, an option premium is based entirely on time or extrinsic value if it has yet to move into the money.
Once the underlying moves into the money, it adds value on top of the time value. For example, let’s say a stock option trader purchases a call for $4 a share and the underlying is below the strike price, the entire $4 represents the extrinsic value of the premium-the cost for the time until expiration. If the underlying moves above the strike price and into the money, the premium will now be made up of the intrinsic value and the extrinsic value. So, if the example stock moves $2 into the money, the total premium might be $6 where $2 is intrinsic value ($2 above strike price) and the $4 is extrinsic value (time value). But now comes the really cool thing.
As an option approaches expiration date, it starts to lose value because there are fewer days for things to happen the way the option trader wants. At first, about 3 weeks out from expiration, the extrinsic value starts to decay. At about 12 days out, the pace of decay really starts to pick up and accelerates toward zero as it reaches expiration. This happens no matter what happens to the underlying. Time decay of extrinsic value is a given. It happens every time.
To take advantage of this inexorable event, an option trader can profit from the decay of extrinsic value. This strategy is called a Time Spread and here is how it works.
Suppose you screen out a stock that is in a sector that is stagnant and not slated to do anything spectacular in the next few months. A trader then looks for a stock that has good option volume and mirrors the sideways movement of the sector. The trader wants the stock to just lay there and do nothing. Now, it is time to set up the position.
The time spread is made up of two options- one sold for the premium in a close month. The other purchased in an out month-usually three months or longer. Both options (both either a call or put) are made as close to at-the- money as possible. The out month will not undergo much time decay but the close in month will zero out at expiration. The net premium gained from the sale of the close month is kept. This can be done multiple times on the same stock unless it comes alive. Little or no movement is the goal to success in this strategy.
For more information on the online courses offered by the Options University, go to www.optionsuniversity.comJoin us this week for the 2nd Annual Investor’s Superconference, in Orlando, FL presented by Options University, June 5th to the 8th, 2008.
