Aug 17 2008
Profit in Death
I know what every stock option will do at expiration. And if every stock option does it, why not make money on that certainty. What I am talking about is the fact that every stock option will expire with zero extrinsic value. Not just a high percentage, but every single stock option. That being the case, is there a way stock option traders can take advantage of this fact?
As you recall, a stock option has two types of value: intrinsic and extrinsic. Intrinsic value is when an option is “in-the-money” and has acquired additional value in respect to strike price. Extrinsic value is basically time value. That is to say, traders will pay a premium to have access to the rights of the underlying stock in hopes that the option will increase in value over the time period of the option. As an option closes in on its expiration date, there becomes less and less probability that the option will increase in value until there is zero chance of it increasing at the time of expiration. As a result, extrinsic value will be zero at expiration. The option is” dead” and there is no chance for any further movement of the option.
Another high probability event is that as the option comes within about 30 days from expiration, the extrinsic value decays at an exponential rate and really noses over within the last two weeks or so. Below is the famous option time decay chart (Extrinsic value).
Writing covered calls is one way to benefit from this phenomenon. As you may remember, writing a covered call means the trader purchases the underlying stock and then writes (sells) a call on the stock for the premium amount. If the call option expires without moving into the money, the option writer can keep the premium and the stock. Many investment advisors consider writing covered calls as a “conservative” strategy. But this strategy demands that the call writer purchase the underlying stock, which can require considerable capital. It’s a nice strategy but there is a much better strategy to also take advantage of time decay and a stagnate stock. But this system requires a small fraction of the capital required by a “buy and write” strategy. I’m talking about an option Time Spread.
A Time Spread involves the purchase of one option and the sale of another in different months, but with both having the same strike. You can construct a time spread using either calls or puts. The caveats are: the same strike price and an equal number of contacts.
For example, a trader will look for a stock that is rather stagnant and will hopefully be so for at least several months. The trader will then look for a strike price close to being at-the-money (premiums are at peak value when ATM). Then, the trader can compare the spread between different months at the same strike price. As extrinsic value does its swan dive in the last 30 days or so, as a result, the trader wants to have a front expiration month which will expire within a month or so. The back month will normally be out at least several months. When the front month goes to zero extrinsic value, which will leave the trader with one position with a little changed premium-at least in comparison to the front month. This position now represents a profit if the back month premium is more than the net cost of the spread position.
For example, let’s suppose a trader sells (writes) a front month call option with a strike that is just out of the money for $2.00 (a time spread can be done with OTM, ITM and ATM). Simultaneously, the trader buys a call option on the same underlying at the same strike price but several months out for a paid out premium of $4.50. The trader will buy the same number of options for each month. As the larger premium is for the purchase, there is a debit of $2.50 per share to assume the spread. When the front month expires, the trader has a debit of $250 for one call. However, the back month should still have a value near its original premium of $4.50. If the back month is closed out, there would be a net profit of $2.00 or $200 per contract. The big difference between writing a covered call and a long time spread is the cost of purchasing the stock to hedge the written call. Without the stock to protect the written call, the trader might have to cover if the stock option is exercised.
There is much more to learn about time spreads and they can be a very cost effective way to use what happens to every stock option.
For a detailed education on other advanced stock option strategies, I recommend the experienced and beginning option trader contact Options University (www.optionsuniversity.com).
Get your free 7 Deadly Sins Report and click here, presented by Options University, and register now for the Forex World Currency Options Class with Greg MaDermott, starting August 18, 2008.
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