Despite the warnings, there’s something titillating about trading long options without protection—you know, buying calls and puts without a hedge. Despite the odds, you may be tempted now and again, like an unsuspecting sailor to a mythical siren’s sweet song. And there’s nothing wrong with that. After all, options can give you substantially more leverage at a fraction of the cost than their underlying stocks. The result is the ability to spend less on each trade, and control more shares than you could otherwise afford—possibly earning you multiples of what you would have made on the underlying stock.
Trading bliss, right? Not so fast. While the leverage provided by long options is alluring, their siren calls mask the risks that have nothing to do with picking the right direction. In fact, you can be 100% right on direction and still lose money. For this reason, rather than focus on how to make money trading long options, let’s focus on the three killers:
1. Time decay
Time Decay: Ecstasy Can Wait
The first thing to know about long options is they’re always losing money. Always. If a stock doesn’t move, it doesn’t lose anything. On the other hand, if a stock doesn’t move, its options lose. Why? Time decay—or rather, theta. Options are time-sensitive instruments—meaning, much like the milk spoiling in the fridge, they have expiration dates. Ignoring these dates can be quite risky, as options lose value each and every day until their last breath at expiration.
Theta is defined as the change in the option value due to a change in time. The theta value that you see on the thinkorswim® platform by TD Ameritrade represents the dollar amount your position loses simply because one day of time has elapsed. (See Figure 1 below.)
In fact, theta happens every day until the option expires. The good news? Options consist of values—real value and time value. This is important because theta only affects the time value of an option. It cannot affect the real value of an option.
A Time Decay Solution. To help mitigate value loss due to time decay, give your option a bit of both. To do this, consider buying in-the money (ITM) options. ITM options have both real value and time value. Hence, deeper ITM options mean a lower percentage of the total option value affected by theta. While you’ll be paying more for an ITM option, it’s likely to move more like the stock you’re trying to mimic, and the option price will still be considerably less than what it would cost you to buy the stock outright. A discount here and there can help take the edge off love gone wrong.
Implied Volatility: Get a Pre-Nup
The heart muscle is formidable but often disappointed. Imagine you buy an option hoping the stock makes a directional move. The stock does just that but you fail to make money. If this is your life, you’ve likely been on the wrong end of a volatility change. Implied volatility helps determine how much time value an option should have. When implied volatility is high, options have a lot of time value, and may be considered expensive. Yet, when implied volatility is low, options have relatively little time value and may be considered cheap.
But how do you know how much volatility is too much? Tech stocks tend to trade at higher volatility levels, while the more established blue-chip stocks tend to trade at lower vol levels. Which one is high relative to itself? It turns out that the best way to determine whether implied vol is high or low is to go back and check past levels and compare them to the present.
Referring to Figure 2 below, the Vol Index on thinkorswim can help with the heavy lifting by analyzing how today’s volatility fares against past levels.
A volatility solution. If current vol is at or near the high of a recent range, it may not be the best time to buy those stock options. Yet, if the level is near the range’s low end, not only could it help mitigate the chance that volatility levels may drop dramatically, but also you may benefit from a rise in the overall vol level. This is because implied volatility is what’s called mean-reverting. In other words, what goes up is likely to come down. But it can also mean that what goes down is likely to come back up. When vol goes up while you’re holding a long option, that’s a good thing. That’s like a mythical story about the bombshell in the elevator who accepts your marriage proposal on the fourth date.
Duration: Soul Mates are Tricky
There’s the old saying: “An option is worth more alive than dead.” Long-term options, namely those with 90 days or more to expiration, have existed for decades. And expiration dates may range from 90 days to several years. LEAPS options can have expiration dates out more than two years. Super LEAPS, and some over-the-counter options, can have even longer life spans. But still, whether five days or five years, they do expire at some point. And one of the most frustrating things to experience in the trading world is to have your options expire just before that big move you expected, where desire and destiny align.
A duration solution. So what can you do? Read a chart or talk to a love shaman, then make your best guess as to when you think the stock will make a move and how long it will take. Beyond that, consider selecting an option that covers your time frame plus a little more. Finally, consider options with at least 90 days or more remaining until expiration. Just give yourself enough time to have the stock do its thing, and try never to bolt out of a trade because you’re racing time on an option that expires in a week. In general, you’re not looking for small fluctuations or an overnight home run. Rather, you’re trading off the notion that a stock is likely to cover more distance if you give it time.
What about Directional Risk?
Since you’re substituting stocks with long options, your choice of strategy naturally suggests you’re comfortable with, and embrace, directional risk. Long options have directional risk, much like trading long or short stock positions. At the end of the day, the stock either moves your way or it doesn’t. Trading is about making one choice relative to another.
Options look like a cheap alternative when compared to the price of underlying stocks. But they’re not a perfect substitute. And they have a defined existence. Further, while stocks only have real value, options have both real and time value. And with that time value comes volatility and time decay. On the bright side, if you’re buying ITM options 90 days out, when vol is historically low, you may not have saved yourself from the call of the sirens entirely, but at least you’ve helped reduce the risks you can control somewhat, and increased the chances of your trade seeing another day.