The Ugly Truth About Buying Options

Now, if you’ve read Why You Should Avoid Trading Options All Together, you’ll know that I’m a huge fan of selling option premium (responsibly).

In fact, I’m constantly surveying the market for unusual options activity… looking for the best trading candidates (using my SIZZLE Method).

Often times, premiums get jacked up after these monster-sized institutional orders hit the tape… that’s when I’ll look to be a seller of high premium (or possibly construct a spread, to slow down the role of time decay and reduce the effect of implied volatility).

I just feel that risk vs. reward it makes the most sense.

However, that doesn’t mean you should never buy options, in fact, being a premium buyer has its own unique benefits. Namely, the opportunity to have greater returns if something extraordinary happens to the stock price of a company.

Of course, it can be very tricky, that is, selecting the right option strike price and expiration period. Hence, most option buyers end up failing falling flat on their face… and end up losing money on their trades.

Are you losing money because you’re buying too much time or not enough?

Are you seeing the stock price move in the direction you predicted, but still end up losing on the trade?

Look, there is a learning curve involved with trading options, and if you answered yes to any of these questions, it’s OK. No one was born with the knowledge to trade options; they all learned from studying and trading the markets.

For many, that means learning from mistakes (AKA paying your tuition to the market… in the form of trading losses).

Besides, I wouldn’t be honest if I told you that I haven’t paid my fair share of tuition in the past.

However, I’d like to think I’ve graduated…and I’m ready to share with you a couple of things I’ve learned about buying options outright.

1. When you buy options, you are not just trading direction. Many new investors think that if they buy a call and the stock price goes up, they’ll make money…or if they buy a put, and the stock price drops, they’ll make money. WRONG!

2. There are several components that go into pricing an option. Most importantly, the price movements of the stock, the option strike price selected, the time to expiration and the implied volatility. The option pricing model is simply a probability model.

3. An option is composed of intrinsic value and extrinsic value.

Example: FACEBOOK on April 1, 2014 closed at 62.62

The mid-price for the 4/ 4/14 (expiration) 61 call is $2.01

Intrinsic value is what the option would be worth if today was hypothetically expiration.

In this case, the intrinsic value is $1.62.

The extrinsic value is the time value and volatility component.

In this case, it’s $2.01 minus $1.62 or $0.39.The mid-price for the 4/4/14 (expiration) $62.5 call

is $1.04

The intrinsic value $0.12 and the extrinsic value is $0.92. As you can see, time value and volatility

consist of most of the value in this option.

Remember, at expiration, all options are left with their intrinsic value.

It’s just another way of saying that they will either expire in the money or expire worthless.

In this case, if the stock settled at $62.62, these options would lose 88% of their current value. With only three days to expiration, you can see how quickly the time value and volatility get sucked out of these options.

4. Only in-the-money options have intrinsic value. With that said, at-the-money and out-of-the-money options have extrinsic value only. The deeper in-the-money an option is, the more the option price will move along with the underlying stock.

An at-the-money option will move with the stock, however, it has to overcome the time value (that is accelerating)…the option may gain value if option volatility rises…or the option may lose value if option volatility drops.

5. Near term option trading is referred to as “trading gamma” and farther out (in time) option trading is referred to as “trading vega”. What does that mean? It means if you select near term options to buy, you are making more of a bet on the directional move of the stock.

If you select farther out options, you are not only making a bet on the direction of the stock, but you are also betting that the option volatility rises. (The option Greek Vega measures the sensitivity to volatility).

Now, there is nothing wrong with trading longer term options that only have extrinsic value, however, most directional traders aren’t really sophisticated enough to have an opinion on whether or not option volatility is cheap or expensive.

In fact, this is where a lot of the mistakes occur. If you are buying at-the-money or out-of-the-money options, you need the directional move to overcome the time decay… and you need option volatility to rise.

Whenever you buy an option outright, you’re always long vega (or option volatility).

A perfect example would be after an earnings announcement…in almost all cases, option volatility gets crushed, sometimes so much…that it overcomes the gain made from the stock moving in your direction, which ends up causing the option to be a loser.

6. Time value always accelerates as we approach expiration. Further, option volatility is a wild card. In fact, it can be driven by a number of different factors.

For example:

Uncertainty- Often time’s option volatility will be elevated in biopharmaceutical companies if they have a pending drug approval announcement. The market doesn’t know if the news will be positive or negative…however, they feel that it will cause the stock price to have a monster-sized move.

A recent case is Mannkind (MNKD). On April 1, 2014, the stock was trading at around $4 per share. The $4 calls and puts (straddle), expiring on 4/4/14 were pricing a +/- $2.40 move.

After the close, their diabetes drug got FDA approval and the stock price gained over 100% in the after-hours.

The following trading day, option volatility got crushed because the uncertainty disappeared.

Supply & Demand- This usually occurs from unusual options activity. For example, on April 1, 2014, Gastar Exploration Inc (GST) saw 7.5x usual options volume.

This demand for options caused the implied volatility in the options to have a huge spike.

In fact, the implied volatility had a change of over 21.2%.

On the flip side, if large option sellers come into the market, the value of the option premium decreases and implied volatility declines.

7. The higher the implied volatility is, the more expensive an option is. The lower the implied volatility is, the cheaper an option is.

8. Delta is the Option Greek that tells us how much we expect the option to move in relation to the stock price movement. For example, if we are long a 50 delta call option, and the stock moves up $1, we can expect to make $0.50 on our option. Keep in mind, we will lose some money from the time decay.

Also, we will make money if implied volatility rises or we will lose money if implied volatility declines.

Ultimately, if you are going to be using options to make directional bets, you want to be trading deltas. Ideally, you’d like the time value and volatility component to be reduced as much as possible.

To get a better understanding, check out these options in FACEBOOK (FB).

FACEBOOK: stock price on April 1, 2014, $62.62Expiration in 3 days

75 Delta Options Intrinsic Value: $1.62 Extrinsic Value: $0.39

53 Delta OptionsIntrinsic Value: $0.12 Extrinsic Value: $0.92

23 Delta OptionsIntrinsic Value: $0 Extrinsic Value: $0.31

Expiration in 31 days72 Delta Options

Intrinsic Value: $5.12 Extrinsic Value: $1.98

50 Delta OptionsIntrinsic Value: $0 Extrinsic Value: $3.93

25 Delta Options

Intrinsic Value: $0 Extrinsic Value: $1.41

Expiration in 81 days 75 Delta Options

Intrinsic Value: $7.26 Extrinsic Value: $2.82

48 Delta OptionsIntrinsic Value: $0 Extrinsic Value: $4.58

23 Delta OptionsIntrinsic Value: $0 Extrinsic Value: $1.68

As you can see, the greater the delta, the more intrinsic value the option has. In addition, the closer to expiration, the less extrinsic value for higher delta options.

Again, if you’re buying options for a directional move, you want to try to reduce the time and volatility component that goes into its pricing.

9. When implied volatility rises, it’s like adding more time on the option. For example, when implied volatility rises, the options are worth more…in a sense, it’s like time was added to the option.

On the flip side, when implied volatility drops, it’s like time was taken out of the option. When implied volatility drops, the option becomes worth less.

Putting it all together

Now, one of the issues that premium buyers have is that they don’t gauge the timing and implied volatility of the option correctly. After all, their thought process is, if I buy a call and the stock rises, my options should increase in value.

As we’ve learned, if you buy an at-the-money option (or an out-of-the money option), the move in the stock price needs to overcome what you’ll lose from the time decay and potentially a drop in implied volatility.

If your goal is for a directional play only, you want to try limit the time and volatility aspect. Forgive me if I’m sounding like a broken record…but I can’t stress this point enough.

How do we do this? Well, there are two ways.

First, buy options with high intrinsic value. For example, buy an option with a delta of 70-75. In many ways this could be viewed as a stock substitute. However, you’ve still got a great deal of leverage and a built in stop.

Often times, equity traders will set stops for themselves, when you buy an option, you’ve already defined your risk.

The benefit of this approach is that there isn’t much extrinsic value in the option. With that said, if the stock doesn’t move much, you won’t get killed in time decay.

What time frame should you buy?

Well, that should be based on your opinion on where you think the stock will go.

Is it a day trade, a swing trade or a longer term position?

By answering this question, you’ll have a better clue on which option contract to select. For example, weekly options are best for day trades, for swing trades you can use options that expire in 14-30 days. Of course, for longer term swing trades you can go out 45 days to 90 days.

Why not longer?

Well, because these options don’t have a great deal of extrinsic value, you can always “roll” the position, meaning close out one contract and buy a later dated month. Now, don’t get caught up in these numbers, it’s really based on where you think the stock will go and by when.

I know traders who will go out 45-65 days on swing trades and 180 days for longer term trades.

There are no hard rules or magic time frames…it’s really based on your opinion.

Now, I’m not saying you can’t make money by buying at-the-money or out-of-the money options…because you most certainly can. However, you’ll need a fast and aggressive move in the stock if you’re trading options with 30 days or less left till expiration.

If you don’t see that, the time decay will melt that option premium away.

When you go farther out in time, you are also betting on volatility to rise. Again, for the average retail trader, volatility is very complicated subject matter. It involves doing analysis on historical volatility and comparing it to implied volatility.

In addition, you have to put it into context… to figure out if volatility is cheap or expensive.

If you’re buying an option because you think the stock price will go up or down, don’t you want to make things as simple as possible for yourself?

I know I do.

Too many times traders get hung up with buying cheap options because they’re cheap and they can buy a lot of them. They feel that they are getting a better deal than buying the more expensive in-the-money options.

Now, the reason why I showed you all those different FACEBOOK options is that I wanted to show you that “expensive” options are actually cheaper than at-the-money and out-of-the money options.

The chances of making money on an out-of-the money option are not favorable. In fact, the odds are actually horrible.

Besides, your goal is to make money on the trade, not to load up on as many option contracts as you can.

Second, you can buy a spread. A long spread is simply a long call (or put) against a short call (or put). Because the option you bought is more expensive than the one you sold, the trade is done for a debit.

Why would we do this?

Well, by selling an option against our long, we are reducing the effect of time decay and volatility.

In essence, it’s another way to play for a directional move. Not only that, but spreads also reduce your overall cost.

Example:

FACEBOOK (FB) options expiring in 31 days, stock price on April 1, 2014 is $62.62

72 Delta calls: $57.50 strike, priced at $7.10 (with an intrinsic value of $5.12 and extrinsic value $1.98)

25 Delta calls, $71 strike, priced at $1.41 (with $0 intrinsic value and $1.41 of extrinsic value)

If you bought this spread, it would cost $5.69. In addition, the intrinsic value would still be $5.12…however, you’re extrinsic value would decrease to $0.57. That means if the stock stayed at the same price on expiration, you’d only lose $0.57.

Not only that, but your break-even point has improved, when compared to buying the outright call. You see, by selling the $71 call, we’ve reduced our exposure to time decay and implied volatility.

Of course, if the stock trades north of $71 at expiration, this spread could yield a return of over 135%…not too shabby.

At the end of the day, you’ve got to be right on your opinion on whether or not the stock will trade higher or lower. What I’ve done is shown you two methods to express that opinion…that reduce the role of time decay and effect of option volatility.

Lastly, I’d like to thank you for this post. You see, I get a lot of questions about this in emails, on Twitter, Facebook and StockTwits. I’d be lying if I said you didn’t inspire me to write this.

“He who asks a question is a fool for five minutes; he who does not ask a question remains a fool forever.”

I really love that Chinese proverb; I think it’s so true. With that said, don’t be shy and keep the questions coming. As always, I’d love to hear your thoughts in the comments section below.