THE OPTIONS COURSE- TIME DECAY

THE OPTIONS COURSE


TIME DECAY

Have you ever heard the expression that options are “wasting assets”? Since options suffer from what is known as time decay, the option contract loses value with each passing day. Therefore, if a strategist buys a put or call and holds it in her account, even if the underlying stock or index makes no price movement at all, the portfolio will lose value. As a result, options strategists must carefully examine how time is affecting their options positions. This section explains how.

Options contracts are agreements between two parties as to the right to buy (in the case of call) or sell (with respect to puts) an underlying asset at a predetermined price. Each options contract has a fixed expiration date. Hence, an XYZ call option gives the owner the right to buy XYZ at a specific price (known as a strike price), and the XYZ put option gives the owner the right to sell 100 shares of XYZ stock at a predetermined price, but only until a certain expiration date.

A stock options contract is valid only until the Saturday following the third Friday of an expiration month. For example, the October 2004 options expire on October 16, 2004. The last day to trade these options is on the third Friday of October, which falls on October 15, 2004. The time left until the option expires is known as the life of the option. As expiration approaches, all else being equal, the life and the value of the option will decline. Some traders use the term time value premium. All else being equal, the greater the amount of time left until the option expires, the more valuable the options contract.

At the same time, the rate of time decay is not linear. As an option approaches expiration, the rate of decay becomes faster. For instance, an option with only three weeks left until expiration will lose time value premium at a faster rate than an equivalent option with 12 months of life remaining. Mathematically speaking, the rate of time decay is related to the square root of the life of the option. For instance, an option with three months of life left will lose value twice as fast as an option with nine months left. 

Similarly, an option with 16 months left will decay at half the rate of an option with four months left. The option’s amount of time decay can be measured by one of the Greeks known as theta. The theta of an option is computed using an option pricing model. Alternatively, it can be found using the Platinum site.

EXITING A TRADE

There are three ways to exit an option trade. An option can be offset or exercised, or it can simply expire. Experience is the best teacher when it comes to choosing the best alternative. In most cases, traders close options through offsetting trades. However, since each alternative has an immediate result, learning how to best close out a trade is a vital element to becoming a successful trader.

Offsetting

Offsetting is a closing transaction that cancels an open position. It is accomplished by doing the opposite of the opening transaction. There are four ways to offset an option transaction:

1. If you bought a call, you have to sell a call.
2. If you sold a call, you have to buy a call.
3. If you bought a put, you have to sell a put.
4. If you sold a put, you have to buy a put.

The best time to offset an option is when it is in-the-money and therefore will realize a profit. Offsetting can also be used to avoid incurring further losses. An option can be offset at any time—one second after it has been entered or one minute before expiration. Offsetting an option is the most popular technique of closing an option. In fact, 95 percent of all the options with value are offset.

Exercising

There are various reasons why a trader might choose to exercise an option versus offset it. Of the 5 percent that are exercised, 95 percent are exercised at expiration. Exercising will close your open call option position by taking ownership of the underlying stock. If you want to exercise a long (bought) stock option:

• Simply notify your broker, who will then notify the Options Clearing Corporation (OCC).
• By the next day, you will own (if exercising calls) or have sold (if exercising puts) the corresponding shares of the underlying asset.
• You can exercise an American option at any time; but primarily you will do it—if you do it at all—just prior to expiration.
• If the market rises, you may choose to exercise a call option. Your trading account will then be debited for 100 shares of the underlying stock (per option) at the call’s strike price.
• If the market declines, you may choose to exercise a put option. You will then receive a credit to your account for 100 shares of underlying stock at the put strike price. This is called shorting the market and can be a risky endeavor.

An option seller cannot exercise an option. By selling an option, you are taking the risk of having a buyer exercise the option against you when market price movement makes it an in-the-money (ITM) option. The OCC randomly matches or assigns buyers and sellers to one another. If there is an excess of sellers by expiration, all open-position ITM short options are automatically exercised by the OCC. In order to avoid being automatically exercised, short option holders can choose to offset or close their options instead.

Letting It Expire

Letting an option expire is used when the option is out-of-the-money (OTM) or worthless as it approaches the expiration date. For short options, letting them expire is the best way to realize a profit. If you let a short option expire, you get to keep the credit received from the premium. Since a momentary fluctuation in price can mean the difference between opportunity and crisis, traders with open positions need to keep track of the price of the underlying asset very carefully. Luckily, computers make this process easier than ever before. There are plenty of web sites that provide detailed option and stock listings, including our own site.

ASSIGNMENT

Assignment is one of the more confusing characteristics of an option. Although it occurs infrequently, it is an important part of basic option mechanics. As an option trader, you’ll need to have a solid understanding of assignment in order to maximize your chances for success. Let’s take a closer look.

Anticipating Assignment

As we have seen, selling puts or calls can involve significant risks. However, there are some strategies that carry relatively low risk, but also involve selling options. Many of these trades are more complex trades that we will explore. For now, let’s assume we sell an option, but we want to determine if there is a risk of assignment. Are all options assigned? When are the odds of assignment the greatest? While there is no way to know for certain when assignment will occur, there are some relatively certain ways to anticipate it before it happens. Recall that sellers take on an obligation to honor the option contract. 

Therefore, if you sell a call option, you agree to sell the stock at a predetermined price until the option expires. On the other hand, if you are a put seller, you have the obligation to buy the stock, or have it put to you, at the option’s strike price until the option expires. When you have to fulfill your obligation to buy or sell a stock, you are “assigned.” Therefore, assignment is the process of buying or selling a stock in accordance to the terms of the option contract. Once assigned, the option seller has no choice but to honor the contract. In other words, it is too late to try to buy the option contract back and close the position.

Although option sellers have an obligation to buy or sell a stock at a predetermined price, assignment will take place only under certain circumstances. How do you know if you are at risk of being assigned? First, exercise generally takes place only with in-the-money options. For example, a call option that has a strike price below the price of the underlying stock is ITM. If XYZ stock is currently trading for $55 a share, the March 50 call options will have an intrinsic value of $5 because the option buyer can exercise the option, buy the stock for $50, immediately sell it in the market for $55, and realize a $5 profit. 

A put option, on the other hand, will be ITM when the stock price is below the strike price. The put is in-the-money when its strike price is higher than its stock price. It is extremely rare for assignment to take place when options are not ITM. In addition, if an option is in-the-money at expiration, assignment is all but assured. In fact, the OCC automatically exercises any option contract that is one-quarter of a point ITM at expiration. That is, options that are in-the-money by one-quarter of a point or more are subject to automatic exercise.

The second important factor to consider when assessing the probability of assignment is the amount of time value left in the option. When an option is exercised before expiration, it is known as early or premature exercise. In general, if there is time value (1/4 point or more) left in the option, the option will usually not be exercised. Option sellers can expect assignment when the option has little to no time value remaining. Since the time value of an option decreases as time passes, the probability of early exercise increases as the expiration date approaches. To determine the amount of time value remaining in a call or put option, traders can use the following formulas:

• Call time value = call strike price + call option price – stock price.
• Put time value = stock price + put option price – put strike price.

Finally, this discussion of assignment applies to American-style options. American-style options can be exercised at any time prior to expiration, while European-style options can be exercised only at expiration. Most index options settle European-style. Stock options, on the other hand, exercise American-style. Therefore, stock option sellers can be assigned at any time before the option expires, and anticipating the assignment is important when using strategies that involve selling option contracts. In sum, the probability of assignment increases as:

1. The option moves in-the-money.
2. The time value of the option drops below 1/4 point.

There are odd times when assignment will take place with slightly out-of-the money options or options with time value remaining. These are the exception, however, and relatively low-probability events.

CASH OR MARGIN ACCOUNTS

Many options strategies require margin deposited with a broker. When we discuss the strategies, we will explain what amount of margin is required for each position. But first, what exactly is margin?

Buying or selling stocks is referred to as a “trade.” For instance, if you decide to buy 100 shares of XYZ and the stock price is $100, you are trading your money for the shares. In this case, the trade is $10,000 for 100 shares of XYZ stock. The exact amount you need to make your first trade depends on a number of factors including:

• Your market selection.
• Size of the transaction (number of shares).
• Risk on the trade.

Your first trade also depends on whether you want to do your trade using a margin or cash account.

Cash trades require you to put up 100 percent of the money in cash. All costs of the trade need to be in the account before the trade is placed. For example, to buy 100 shares of IBM at $100 per share, you would have to pay $10,000 plus commissions up front.

Margin trades require traders to only put up half the total amount to purchase shares while their brokerage lends them the other half at a small interest rate. So for the same IBM example you would have to pay $5,000 plus commissions up front.

The term margin refers to the amount of money an investor must pay to enter a trade, with the remainder of the cash being borrowed from the brokerage firm. The shares you have purchased secure the loan. Most traders prefer a margin account because it allows them to better leverage assets in order to produce higher returns. In addition, a margin account is usually required for short positions and options trading.

Based on Securities and Exchange Commission (SEC) rules, the margin requirement to purchase stock equals 50 percent of the amount of the trade. At this rate, margin accounts give traders 2-for-1 buying leverage. If the price of the stock rises, then everyone wins. If the price of the stock falls below 75 percent of the total value of the initial investment, the trader receives a margin call from the broker requesting additional funds to be placed in the margin account.

Brokerages may set their own margin requirements, but it is never less than 75 percent—the amount required by the Fed. Brokerages are usually willing to lend you 50 percent of a trade’s cost, but often require a certain amount of money be left untouched in your account to secure the loan. This money is referred to as the margin requirement.

Of course, brokers don’t lend money for free. They charge interest on the loan amount over and above the commission on the trade. The interest and commissions are paid regardless of what happens to the price of the stock. The margin’s interest rate is usually the broker call rate plus the firm’s add-on points. This rate is cheaper than most loans, as it is a secured loan—they have your stock, and in most cases will get their cash back before you get your stock back.

Ultimately, there are no absolutes when it comes to margin. Combining the buying and selling of options and stocks may create a more complex margin calculation. However, these strategies usually have reduced margin requirements in comparison to just buying or shorting stocks alone. Since every trade is unique, margin requirements will depend on the strategy you employ and your broker’s requirements.

Margin calls, which are demands from brokers for more money, are a reality that traders have to deal with every day. Unless you have a crystal ball that forecasts the future, there are no sure bets. Obviously, the larger your capital base becomes, the less you have to worry about margin. But it’s always a good idea to keep margin in mind and not let yourself get overextended, no matter how enticing that “just one more” trade looks.

While stock trades usually require a 50 percent margin deposit from your account to place depending on your brokerage, margin requirements on futures markets vary from commodity to commodity. Similarly, the amount of margin in the options market depends on the nature and risk of the position as well as your brokerage’s discretion.

CONCLUSION

The options market is a fascinating place that continues to grow in popularity today. Like any derivative, options can carry high risks when not respected or when used carelessly. At the same time, options on stocks, futures, and indexes can offer huge rewards to those savvy traders who have studied them well. So far, we have covered only the mechanics of options trading. By now, you should understand the difference between a put and call, the factors that determine and influence option prices, why options are known as wasting assets, and how to use symbols to retrieve options quotes.

We move on to the topic that really matters: how option strategies make money in the markets. As we will see, a profuse number of different strategies can be used to generate profits whether we expect a stock to move higher, move lower, or stay in a narrow price range. Some strategies are very simple, and some are more complex. Regardless, there are several important factors to be considered when reading through various options trading strategies. 

Which ones make the most sense to you? Which ones feel right? Which trading strategies are you most comfortable with? Try to identify only one or two, because in the beginning you will want to specialize and concentrate your efforts on just a few strategies. It can prove overwhelming if you try to master them all (to do so can take a lifetime), which is one of the major reasons I find options so fascinating.

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