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Options are instruments of probability. They are priced using a complex mathematical formula which boils down to the measurement of two variables: (1) Intrinsic value (or how much “in the money” it is), and (2) ‘Time and Probability’ value (most commonly just known as time value). Understanding these two variables is key to trading options profitably.
Far too many traders lose money simply because they don’t understand how market makers adjust option pricing in their own favor. The following simple truths about option pricing will help you recognize where option prices are likely to end up, and the probabilities associated with that final outcome.
Because these concepts are true, they lead to three important trading corollaries:
This lesson will explore each of these simple truths and their corollaries to help you understand how you can use the probability profiles and trading edge you learned in previous lessons to maximize profits in your option trading.
Truth #1: Option Prices are Set by the Market Makers
Option market makers use a Nobel prize winning formula and fast computer technology to help them make a market in the derivatives known as options. This formula incorporates many variables which can be boiled down into just two basic components: Intrinsic value and time value.
Intrinsic value is determined by the relationship of the option’s strike price to the underlying’s current price. Intrinsic value moves dollar for dollar as the underlying moves. Meaning if the underlying goes up $1, the call option’s intrinsic value will also go up $1. If the underlying falls in value, the intrinsic value of the call option falls at exactly the same rate. Put options are the opposite. If the underlying drops $1 in value, a put option’s intrinsic value will rise $1 and if the underlying rises in value by $1, the intrinsic value of the put option drops $1. Intrinsic value will always either be positive or zero.
The time value (not the intrinsic value) portion of an option’s price is where the market maker adjusts the price to insure they keep their probable winning percentage at 70%. This means the market maker will inflate or deflate the price of time in response to changes in both the macro environment and conditions of the underlying equity. Time value is also a decaying asset because it loses value as time passes. Therefore, time value both fluctuates and constantly decays as time passes and will eventually be worth zero at expiration.
If expectations are high that the underlying will increase in volatility (like around earnings), market makers raise the price of time to keep their expected winning percentage at 70%. The converse is also true, they’ll reduce what they charge for time during periods of lower volatility. More advanced traders and strategies make use of these factors that affect the price of time and as you gain in experience, you may find a need to learn these advanced features. But for now, the simple approach is to understand time both fluctuates in price and decays in value with each passing day and will eventually be worth nothing on expiration.
Trading stock differs from trading with options because options have more moving parts such as expirations dates, puts versus calls, a wide variety of strategies and the impact on time value from market expectations. The two biggest risks to those who trade option is expiration date (the option eventually expires) and time decay. Not only does a person need to keep track of direction (up vs. down), but they must also keep an eye on all these other factors. Some have compared stock trading to the game of checkers and options trading to chess—and rightly so.
This module will help you better understand the two primary ways to open an options position: Either as a buyer (speculator), or as a seller (cash flow generator). Time decay works against a buyer and for a seller. You can be either (or both) an options buyer or seller depending on the strategy you choose. Understanding how options are priced helps you select the best option strategy to implement based on your probability profile, your forecast, and your system.
Time Value and Intrinsic Value
The most important variable you need to understand is the fluctuating nature of the value of time and the continual erosion of its value each passing day. Time loses value faster as an option approaches its expiration. For an option to be profitable on expiration, any loss of time value must be recouped by an increase in the option’s intrinsic value.
The time value represents a mathematical calculation about how much the underlying could move given the amount of time left before expiration. This mathematical estimate includes everything that goes into pricing an option except its intrinsic value. Option market makers refer to this combination of factors as implied volatility. We’ve referred to it as time value. Whatever you choose to call it, remember that it can fluctuate and become more or less expensive due to market conditions, that it decays in value over time, and that it always works against an option buyer and for an option seller.
Conversely the intrinsic value of an option is easy to determine. Simply compare the option’s strike price to its underlying’s price. It will always be either positive or zero. Call options (right to buy) have intrinsic value when the strike price is lower than the current price because you have the right to buy the stock for less than its current price. Put options (right to sell) have intrinsic value when the strike price is higher than the current price because they give you the right to sell the equity for higher than its current price. Options are usually displayed in tables (known as chains) with different color schemes making it easy to see which options have intrinsic (in-the-money) value and intrinsic (out-of-the-money) value.
For example, if a Call option gave you the right to buy the stock at a strike price of $40, and the equity currently trades at $42.23, then your option would have an intrinsic value of $2.23 ($42.23 current price – $40 right to buy price = $2.23 of intrinsic value). If the option cost $5.43, then time value would be $3.20 ($5.43 price of the option – $2.23 intrinsic value = $3.20 time value). On the other hand, a put option in this example would have zero intrinsic value ($40 right to sell price – $42.23 current price = -$2.23…a negative intrinsic value is automatically set to zero). If the $40 put option cost $3.20, the entire price is time value since the put option is out-of-the-money.
If the equity increases in price to $45 at expiration, the intrinsic value increases exactly as you might expect, penny for penny; while the time portion of the option’s price would continue to fluctuate based on market conditions and also constantly erode until expiration when it reaches zero. In this example, the $45 equity price at expiration is $5 higher than the $40 strike price of the call option. This call option has an intrinsic value of $5 which means the option ended up losing $0.43 at expiration because $5.43 original cost – $5 current value = $0.43 loss.
The only way for this (or any) option to be profitable on expiration is for the in-the-money value to move more than the amount of time value lost to time decay (in this case $3.20).
Options can be bought and sold at any time, it is not necessary to wait until expiration before selling a profitable option. In fact, it is often better not to wait until expiration before liquidating your option positions. Using this losing trade as an example, it is very possible that the equity moved around enough before all of the time value decayed for this option to have been profitable at some point during its lifespan.
Changes in Time value vs Intrinsic Value
If the underlying moves above the strike price of a call option by $1.00 over the course of a few days, the intrinsic value increases by $1.00, but the time value decreases because of the passage of time and fluctuating needs of the market makers. Awareness of how much is paid for the time portion of an option gives you a sense of how far the underlying must move in the desired direction for the option to be profitable on expiration. The following figure demonstrates how the price of a call option both fluctuates and decays over time in comparison to its underlying’s price. The intrinsic value is depicted in green, while the time value is depicted in red.[/vc_column_text][vc_single_image media=”4426″ media_width_percent=”75″ alignment=”center” border=”yes” shadow=”yes” shadow_weight=”sm” shadow_darker=”yes”][vc_column_text text_lead=”yes”]In this 90 day hypothetical example, the stock starts at $41.75 and fluctuates upward until it closes at $47.75 on the expiration date of the $40 call option also depicted. The initial price of the option is $3.75 of which $1.75 is intrinsic value (in blue) and $2.00 is time value (in yellow).
This chart demonstrates how the stock and option prices vary in a related but not exact fashion over time. Notice four important concepts shown in this figure:
Understand that the time portion of an option’s price is influenced by both the passage of time and the rise and fall of implied volatility (or the effort by the market makers to insure a 70% winning percentage for themselves). Keeping this in mind helps you make better options trading decisions. As we’ll show in future instruction, there are a number of different strategies for trading options which take advantage of this central truism about the value of time.
Truth #2: Option are priced so that they decrease in value more often than they rise
Truth #3: Option market makers price the option to win 70% of the time.
These two truths are closely related so we’ve combined them into one discussion. The truth is options are not like stock. A stock buyer can hold the stock forever. Options traders don’t have that luxury. Stock buyers can set stop losses and profit targets to give them a mathematically proven statistical base winning percentage. Options traders don’t have that luxury. The initial price of an option is set by (and in favor of) the market maker and the reality that time value decays and the option will eventually expire present real danger to option traders.
But, options also present such an exciting and potentially lucrative range of possibilities for profit that every investor and trader should make implementing them a priority. Any percentage move in the stock creates a much bigger percentage move in the option. Option buyers put less money into the trade (risk less) and have the potential to make a large multiple on any move in the underlying makes in the desired direction.
Additionally, options give people strategies to take advantage of every kind of market. There are cash flow strategies, market neutral strategies, protection strategies and speculation strategies. Each of these strategies key in on the corollaries mentioned above:
These corollaries align well with the probability profiles discussed in lesson 1. The Win Frequently probability profile often employs option selling strategies. The Win Big probability profile often employs option buying strategies. The Just Win probability profile is flexible enough to enter trades either as a buyer or a seller. Future lessons will explore the risks and rewards option buyers and sellers both face as they implement the various strategies you’ll learn through your course of curriculum.
Risks and Rewards for the Option Buyer
Option buyers are speculators and they like volatile markets. The underlying has to move enough in the right direction for their positions to make money. All option buyers face the risk that the time value of their purchased option will decay faster than the intrinsic value will rise before the option expires. For option buyers to make money, they need the underlying to move far enough in the desired direction that intrinsic value increases faster and further than the loss of time value. It’s possible to buy an option, have the underlying move in the right direction and still lose money because time lost value faster than intrinsic value appreciated.
Market makers always create a series of options with strike prices above and below the current price of the underlying for each expiration date. This gives the option buyer several choices to select from as they seek to implement their strategy. There are trade offs to buying options above or below the the current price of the stock which individual strategies will teach.
Remember there are two basic components of an option’s price: Time value and intrinsic value. Options with more intrinsic value cost more but time value makes up a smaller portion of the overall price and are therefore more likely to expire with some value. Options with no intrinsic value are comprised only of time value and these options have a greater chance of expiring worthless though they can be much more profitable on a percentage basis if the stock does as expected.
The Win Big (risk 1 to make 2) and the Win Big Extreme (risk 1 to make 3+) trading styles look for conditions where the underlying is likely to move farther and faster than the odds would predict. They expect to only win 30-40 percent of their trades and are therefore prepared to make trades that can deliver realistic gains of double or triple the amount they risk.
Our curriculum gives you a way of looking at the market and finding your edge in forecasting both the direction and the magnitude of a trade. Whatever you use to determine the trade setup, understand that active option buyers must be prepared to endure losing streaks of 8 or 9 losses in a row over the course of 6 months to a year. Option buying can still be a highly profitable trading strategy with proper trade management (taking small losses) and portfolio balancing. Once properly understood, losing streaks can simply be a psychological hurdle rather than a financial one.
One exception to this rule is that put buyers may be both speculators and insurance buyers. If you own an equity you can’t (or don’t want to) sell and believe it may about to lose value, buy a put option as insurance. The equity will drop in value as the put option rises in value, protecting your assets. Some people purchase insurance on their entire portfolio using index put options.
Winning as an Option Buyer: Establishing Success Criteria for Entry
Option buyers must find excellent opportunities that provide a defined loss when they are wrong, but are capable of generating proportionally larger winners if they are right. The buyer further refines their strategy by timing the purchase to correspond with some additional components like technical analysis, unusual trading volume, unexpected news, earnings, etc, that could rapidly change the price of the underlying and thereby the price of the option. Option buyers love volatility. Anything that adds to movement in the underlying gives them a bigger chance for higher percentage gains in their options.
Most option buyers don’t use fundamental analysis or other long-term trading tools, focusing instead on short-term technical analysis. Listen carefully in class to identify possible screening criteria and then create a checklist to identify potential trades.
Below is a sample list of potential criteria:
We asked you to identify 10 random stocks to paper trade using just the risk/reward characteristics of your natural trading style (risk 1 to make 2, etc). As an exercise, go back to those 10 random stocks (or select new ones) and do the same thing (set stops and profit targets according to your probability profile) only this time only enter a trade using one of the potential criteria listed above. Continue following these stocks over time even as you paper trade the setups you see in class.
Trading Options Systematically (as a Buyer)
The following is a list of option strategies that buyers might employ and the probability profile associated with each. Though there are many options strategies that can be profitably traded, these are the most reliable for traders new to option strategies. You should discuss this list with your instructor so that you can select those strategies you would like to learn more about.[/vc_column_text][vc_single_image media=”1533″ media_width_percent=”75″ alignment=”center”][vc_column_text text_lead=”yes”]Risks and Rewards for the Option Seller
The single biggest risk a call option seller has is the exact same risk of those who buy stocks, ETFs and other underlying equities: They can drop in value. The second biggest risk is lost opportunity. When sold to open a position, call options obligate the seller to sell their underlying equity at the strike price of the option. This obligation to provide the underlying at the strike price limits (or caps) the profit of the underlying at the strike price. Option sellers limit the potential upside of their positions in exchange for capturing a desired and defined premium (paycheck). They hope to make many small paychecks on a high percentage of their trades without having the underlying drop enough to wipe out all their cash flow gains.
Remember, time decay works against an option buyer….but it works FOR an option seller. Also remember that “time” is what we’ve been calling the portion of an option’s price which is not intrinsic value and that “time” is where the market maker manipulates the option’s price to give them a 70% chance of winning.
Remember one of the truths about option pricing: Options are priced so that they decrease in value more often than they rise.
Option sellers understand this truth and have positioned themselves to profit from it. The advantages of approaching options as a seller are real. Option sellers can be profitable if the underlying moves in their favor, stays the same, or even moves against them a little bit.
Those who sell options may choose from any and all the available options for that underlying. There are advantages to selling more or less time and advantages to selling more or less in the money. Future curriculum will explore a number of option strategies and help you match strategies to your natural trading style.
Winning as an Option Seller: Criteria for Success
Option sellers obligate themselves to buy (in the case of puts) or sell (in the case of calls) the underlying at the strike price of the option sold. They receive a premium (paycheck) in exchange for this promise to either buy (puts) or sell (calls) the underlying at the strike price. The safest way to employ this strategy with calls is to own the underlying or another call option. This is known as a “covered call.” Selling calls against stock or options you own has been deemed safe enough to do inside an IRA or other self-directed retirement plan. Selling a call option carries the same risks of equity ownership: The underlying could lose significant value. Beginners should only employ this strategy on stocks or ETFs which are bullish or neutral, not bearish.
Put option sellers obligate themselves to buy the equity at the strike price by expiration. The safest way to employ this strategy is to only do it on equities you like and wouldn’t mind owning and to only obligate yourself to buy the shares that you have cash on hand to pay for (no leverage).
The times that tend to create excellent opportunities for sellers are when there is excitement and high expectations in the market. Market makers tend to price options higher during these times even though the underlying is also likely to go up or at least stay the same. These trades generate small but consistent paychecks with a lower chance of the underlying losing value. If you carefully invest in equities you like anyway, and manage the risk of equity ownership, you can be very successful as an option seller focused on generating cash flow from the markets.
If you have a source of option trading ideas, such as our research tool, a subscription service you trust, or a well-chosen set of screening criteria from other sources, then you can use the following checklist to help you identify your option candidates from among the trading ideas you accumulate:
For each potential candidate, review the chart and answer the questions below:
As an exercise, work through a random company to see how many characteristics your candidate has from this list. A simple rule of thumb is that three or more of these mean it is likely a strong candidate for a successful implementation of the covered call strategy. Once you feel more comfortable with these characteristics, you may add one or more of these (and others that you learn about) to your Trade Plan (which we’ll teach in the next lesson).
Trading Options Systematically (as a Seller)
The following is a list of option strategies that traders might employ when acting as the option seller. The probability profile associated with each strategy in this list is a default, though each of these strategies can be adapted for different probability profiles. Though there are many options strategies that can be profitably traded, these are the most reliable for traders who are new to options.[/vc_column_text][vc_single_image media=”1532″ media_width_percent=”75″ alignment=”center”][vc_column_text text_lead=”yes”]Some of these strategies may be new to you and some of them may require additional permission from your broker to trade. As you look over these strategies and the rest of the information presented in this lesson, think about which approaches seem most appealing to you. Once you have singled out a strategy, add it to your Trade Plan and begin paper trading it for experience and to build your confidence and anticipation to trade it with real money.
There are a great number of inventive strategies for using options in various ways and in various market conditions. Options can be bought and sold singly or combined with other options defined strategies. Our tool has some built in searches to help you find opportunities in a range of strategies and market approaches. Here is a screenshot showing some of the various strategies we’ve already programmed into the tool:[/vc_column_text][vc_single_image media=”1539″ media_width_percent=”100″ alignment=”center”][vc_column_text text_lead=”yes”]As you can see, our trade tool offers a number of strategies which might seem overwhelming to you right now. There is no need for worry. We’ll teach you about each strategy as we use it to make paper trades in class. Each strategy has its profit potential and each one also has a risk of loss. Approaching these strategies through the lens of your natural trading style will help you focus on those few strategies you should begin with. These strategies (and your natural trading style) is your home base. Start practicing with options using strategies and combinations that fit your style now. You can always cautiously expand into other probability profiles with their corresponding strategies, base winning percentages, and expected winning/losing streaks later after you’ve gained confidence in your natural style and have begun making consistently profitable trades.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column][/vc_column][/vc_row]