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9 Lesson Option Course
Lesson 2 - Options Are A Decaying
Asset.
As an option gets closer to expiration,
it losses value. So by selling options, everyday
that goes by, makes you money. I call it Selling
Time.
Have you ever heard the song, Time is On My Side
by The Rolling Stones?
If yes, then you know what it feels like to be
an option seller. Everyday that goes by, the options
I sell lose value. And that means I am making
money.
Let's use an example:
IBM stock is at $80. I sell you an option that
expires in 30 days that allows you to buy IBM
at $100 ($100 is the strike price of the option.).
I charge you $1 for this option.
Now each option controls 100 shares, so this
option worth $1 actually costs you $100. The only
way you will make money is if IBM goes above $101
($100 plus the $1 cost of the option) within 30
days. If IBM stays below $101, I make money.
The clock is ticking. Tick tock. Time is on my
side. By the way, even though the markets are
closed Saturdays, Sundays, and Holidays, options
still lose value on those days. So the 30 days
until expiration is 30 calendar days, not 30 trading
days. Cool huh?
The seller of an option attempts to benefit from
the decay of the option's time value. Time value
captures the possibility, however remote, that
the option may increase in value due to the changing
value of the underlying stock. This value depends
on the time until the expiration date and the
volatility of the underlying stock's price.
If the underlying stock's price has not been
reached by the strike price of the option, the
option is considered to be out of the money. As
time passes, if the option remains out of the
money, the option gradually loses its time value.
The time value of an option is always positive
and declines exponentially with time, reaching
zero at the expiration date. Upon expiration,
if the option is still out of the money, the option
will have no value left, and it will expire worthless.
Its holder will simply abandon the option leaving
the option seller with the premium. (Premium is
jargon for amount paid for the option.)
The entire premium for which I sold the option
will be in your account, less commissions and
fees. At that time, your position closes out automatically.
The graph above illustrates the accelerated decline
of time value as expiration draws near. The graph
allows you to see why an option is considered
a "wasting asset". Time value erodes
as each day passes. The rate at which the time
value is eroding increases as the option's expiration
nears. Notice that the time value decays the fastest
during the last days of the option's life.
Notice how the option loses value fastest in
the last 30 days. Because of this, we sell options
no longer than 50 days left to expiration. We
want our options to expire 50 days from now or
sooner. The amount depends on the strategy used.
Sometimes we can make 20% in a couple weeks, other
times we make 10% in 40 days. It depends on the
market and strategy used. But it is best to sell
options 60 days or less to expiration to get as
high a theta as possible. Theta is jargon for
the amount an option loses value each day. So
if an option has a theta of 10, that means that
option will decline in value $10 each day.
In many cases, we don't even need to wait until
the option expires to get out of the trade. Let's
say we sell an option for $1, and 21 days later
the option is worth 10 cents. We just made 90
cents. We should just buy back the option we sold
for 10 cents and move on to the next trade. Even
though we can make another 10 cents, it might
not be worth it. We might find another trade that
we can better use our money for. Getting out also
locks in our profit.
So let's say we do a trade that has a maximum
return of 12% in 50 days. If after 30 days we
are up 9% it might be best to take the money and
run. Instead of making another 3% in 20 days,
we can probably find another trade that can generate
a better return in the same amount of time.
In our next lesson we are going to learn how
to make money on a stock whether it goes up, down,
or sideways.
Let's Go to
Lesson 3
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