Let’s not beat around the bush: profiting from buying options is difficult. When you’re correct, your potential for big profits is great. But it can be difficult to be correct. However, if you understand what obstacles are in your way and how an option’s premium rises and falls in value, you can increase your chances of success.
You may have heard that buying a new car is a bad investment. There are a few reasons why this is the case. First, cars often lose value as soon as you drive them off the lot. Second, cars are at risk of wreck or damage. Third, cars depreciate in value over time. An option is similar. Let’s see how.
When you trade an option, you typically buy at the ask price and sell at the bid price. The ask price can be like paying sticker price for a car. If you try to sell the car to someone else, you’ll probably get less than what you paid. With an option, you usually sell at the bid price, which you can see in Figure 1 is generally less than the ask price. So if you buy at the ask price and immediately sell at the bid, you'll experience a loss.
The risk of crashing and depreciation in options comes by way of the premium value. You can divide an option's price into two parts: intrinsic and extrinsic value. The intrinsic value is the difference between the stock price and strike price. The extrinsic value is the difference between the option's premium and the intrinsic value.
Some options don’t have intrinsic value and are entirely made up of extrinsic value. Option traders say these options are out of the money (OTM). Therefore, options with intrinsic value are in the money (ITM). On a side note, the option with the strike price closest to the price of the underlying stock is at the money (ATM). The ATM option may or may not have intrinsic value.
Extrinsic value is the cost of owning the option, like the markup on a car over the cost of production. This is the part of the option that depreciates. A car also depreciates in value until it gets down to simply parts and/or scrap metal. Parts and scrap metal can be thought of as the intrinsic value of a car. When it comes to options, it’s the extrinsic value that slowly melts away.
Extrinsic value has two parts: time value and implied volatility. We’ll talk about them as if they are two different things, but in effect, they’re combined. Time value is the part of the premium that corresponds to the time to expiration. This is the part that depreciates. Implied volatility is the part of the extrinsic value that responds to potential price fluctuations. Volatile stocks have higher implied volatility and therefore higher extrinsic value and higher premiums. In a sense you pay for the potential of performance, like with a sports car.
Less volatile stocks with smaller price movements have lower implied volatility and smaller premiums. Like an economy car.
But implied volatility changes as the underlying price changes. In fact, usually the stock price is falling when implied volatility is rising. This means the owner of a put option could benefit both from a falling stock price and increasing implied volatility. However, increases in implied volatility are still subject to time decay. This means the option seller may need to be patient.
Right on Options?
So what does it take to be a successful option speculator? Well, first, you have to be right on the direction and the magnitude of a move in the underlying stock price. Second, you have to be right on when the move will happen. And third, you have to know how implied volatility will react. Let’s talk about these.
The bottom line is that you have to be right on the direction and magnitude of the underlying stock. Say you buy a call option. You’ll need the stock to rise to the combined cost of the extrinsic value and the cost of commissions and other fees just to break even. However, long call options have nearly unlimited return potential.
Next, you need to have a timeline in mind for your trade. This is because time decay costs you money each day. If the stock isn’t moving or is moving the wrong way, consider closing the trade to avoid incurring greater losses.
Finally, you have to know how implied volatility will react. Generally speaking, implied volatility rises when the stock price falls and falls when the stock price rises. This means put buyers may be able to enjoy the benefits of rising implied volatility if the timing of the trade allows you to take profits before the time decay eats away the extrinsic value.
In short, you need an investing plan that helps you determine what to buy, when to buy, how much to buy, and when to sell. This plan will help you preserve capital when speculating with options. Investools® from TD Ameritrade Holding Corp. can help traders build investing plans for options as well as stock strategies.
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