Sheridan Options Mentoring Blog |  |
| Posted: 03 Nov 2011 10:15 AM PDT  Buy the Steak and Sell the Sizzle One of the unique characteristics of options is the ability to arrange probabilities to increase the odds of a successful trade. In my last missive, I discussed putting the wind at your back by selecting trades that benefit from high probability changes in implied volatility. Following on that the theme of stacking probabilities in our favor, I thought it would be interesting to look at using time to our advantage. Remember that the three major factors that govern the price of options are: price of the underlying, time to expiration, and implied volatility. Of these three factors, only time can move in just one direction. It is because of this unique attribute that I find trades constructed to benefit from the passage of time are particularly attractive. In option lingo, these trades are the various members of the "theta positive" trades. An inescapable characteristic of this group of trades is that the position must contain at least some component of short options. No position constructed entirely of long option positions can ever be theta positive. A simple example of a positive theta trade is that of selling a naked put. As I write, AAPL has closed at $398. The trader who is bullish on this stock could sell an out-of-the-money December 350 strike put to establish a theta positive trade. This position has a statistical probability of success of around 90% and a one lot position has a current daily theta decay of $13.85. By combining option positions into trade structures composed of one or more legs, probabilities of a successful trade can be enhanced in some intriguing ways. Now let's consider for example a "vertical" spread in December options for AAPL for our bullish trader. This spread could be constructed by buying the Dec 390 call and selling the Dec 395 call in equal numbers. At current prices, this spread is entirely in-the-money and can be purchased for around $3.25. The interesting characteristic of this spread is that its current intrinsic value is $5. We have sold enough "sizzle" in the form of time premium to reduce our outlay for "steak" in the form of intrinsic value. We are purchasing the current $5 in intrinsic value for $3.25. It is important to understand that most or all of this intrinsic value can only be realized by the trader under one of two circumstances: 1. AAPL stock trades at $395 or greater at December expiration. 2. The spread goes so deep in the money that both options trade at essentially intrinsic value (remember that deep in-the-money options have very little extrinsic premium). Note: The risk is that the stock trades under the $398.25 break-even point at expiration. Nothing in the world of trading is a "sure thing". Our job as option traders is to construct positions to maximize the probability of success. Using the passage of time to our benefit is a major advantage the knowledgeable option trader brings to the table. |
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