If Shakespeare traded options, I'm sure he would ponder: "More time or less, that is the question."
And rightly so.
Because aside from determining whether you're going to buy a call or buy a put, deciding how much time to get on your option is probably one of the most grave elements in options trading.
Today we're going to answer this age-old question.
Let's start by taking a look at some examples.
Buying Calls and Puts
Buying calls and buying puts is one of the most common ways investors trade options.
* If you have faith in the price of a stock will go up, you can buy a call option on it and make money as it goes higher
* If you think the price of a stock will go down, you can buy a put option on it and make money as the price goes lower.
The option buyer also gets a guaranteed limited risk, which is limited to the purchase price (or premium) plus any applicable commissions and fees.
Basically, at expiration, your profit is dependant on the difference between where the stock price is and your option's strike price.
What's Your Time Worth?
As a rule of thumb, if you're buying an option, buy more time than less.
The more time you have, the more time value there is.
Many investors will skimp on time in hopes of saving a couple hundred dollars on their purchase price.
It's a simple mistake, but it can be costly.
Example:
Let's look at three hypothetical options; all at the same strike price:
* there's a 2 month option going for $5.00 (or $500)
* a 4 month option going for $7.20 (or $720)
* and a 6 month option going for $9.30 (or $930) Some simple math will quickly show you which options are the better bargain.
For the 2 month option, divide the premium ($500) by the amount of time remaining (2 months). That means each month of time costs the investor $250.
Now take the 4 month option, divide that premium ($720) by the amount of time remaining (4 months) and you'll see that the investor would only be paying $180 for each month of time he/she gets to hold onto that option.
The 6 month option is even better ($930 divided by 6 months) as you're only paying $155 per month of time in this case.
Using the examples above, the 6 month option is the better bargain in that you're paying less for each unit of time than the others.
Of course, if you really don't feel you want (or need) that much time, the 4 month option would still be the better bargain than the 2 month option.
I know that when someone pulls the trigger on a trade, they're likely expecting it to move right away. And it very well might.
But what if it doesn't?
You might have to wait around longer that you thought to see the stock do what you expected it to do.
So while you don't need to buy excessive time, as a general rule, it's usually a good idea to get a little extra time. This is true for two major reasons:
1.If you run out of time, it's game over on that option. And sometimes the variation between making money and losing money in options comes down to just a little extra time.
2.Time value shrinks (time decay) at its most rapid pace within the last 30 days or so prior to expiration. The simple act of getting a little extra time can keep you out of that 'time-value-crunch' red zone.
So when deciding which option to buy, consider getting a little more time than you think you'll need. That'll increase your chances of success by giving you more time for the trade to work out, and as the above illustration shows, it's often times the better value.
Except for the times when it's not. (See below.)
Straddles and Strangles
A Straddle or a Strangle involves buying both a call and a put at the same time.
As discussed earlier, you buy a call if you expect the market to go up.
And you buy a put if you expect the market to go down.
A Straddle or a Strangle is a strategy to use when you're not sure which way the market will go, but you believe something big will happen in either direction.
For example, let's say it's earnings season and you expect a big move to occur, either up or down, based on whether the company reports a positive surprise or a negative surprise.
With these strategies you can make money in either direction without having to be bothered about whether you guessed correctly or not.
(I'll get to the 'how much time to get' in just a moment.)
First, a Few Definitions
* A Straddle is when you have both a call and a put, with the SAME strike price (both at-the-money usually) and with the same expiration dates.
* A Strangle is when have you have both a call and a put option, with DIFFERENT strike prices (both out-of-the-money) and with the same expiration dates.
Both strategies are used to position oneself on either side of the market in an effort to take advantage of a potentially big move in either direction.
Once again, this could be before an earnings release, or a key announcement, or a big report, or maybe the charts are suggesting a big breakout could be getting ready to take place in one direction or another.
Whatever the reason, this is generally when someone would apply this type of strategy.
Example:
Let's say a stock was trading at $100 a few days before their earnings announcement. So you decide to put on a Straddle by buying:
* the $100 strike call
* and the $100 strike put Since you only plan on being in the trade for a few days (to maybe a few weeks), you decide to get into the soon-to-expire options.
But isn't getting more time usually better?
Yes, when buying a call OR a put.
But when playing both sides of the market simultaneously for an event you expect to take place in the near immediacy, the opposite is true.
Why? Because at expiration, your profit is the difference between how much your options are in-the-money minus what you paid for them. So if you don't need a lot of time, this keeps the cost down and your profit potential up.
Continuing with the example above...
If you paid $150 for an at-the-money call option that will expire before long and another $150 for an at-the-money put option that will expire shortly, your cost to put on the trade was $300 (not including transactions costs).
If that stock shot up $10 as a result of a positive earnings surprise, the call option that you paid $150 for would now be worth $1,000.
And that put option would be worth zero ($0).
So let's do the math:
If the call, which is now $10 in-the-money, is worth $1,000; subtract the $150 you paid, which gives you an $850 profit on the call.
The put, on the other hand, is out-of-the-money, and is worth nothing, which means you lost $150 on the put.
Add it all together, and on a $300 investment, you just made a profit of $700.
Pretty excellent - especially for not even knowing which way the stock would go.
If however, you paid more for each side of the trade, those would be extra costs to overcome. But by keeping each side's cost as small as reasonably possible, that leaves more profit potential on the winning side and a smaller loss on the losing side.
Moreover, if the stock stays flat (in other words, the big move you expected doesn't materialize, thus resulting in both sides of the trade expiring worthless), your cost of the trade was kept to a minimum.
So buying a Straddle or a Strangle, by its very nature, should be looked at as a short-term trade.
And if the event that initially got you into the Straddle or Strangle now has you strongly believing that a continuation of the up-move or down-move is in order, you could then exit the Straddle or Strangle and move into the one-sided call or put and apply the 'more time' rule as discussed earlier.
Record Setting
In spite of all the turmoil in the financial markets of late (or maybe, in part, because of it), the growth in options trading has continued to rise.
In fact, for the last seven years in a row, the volume of options contracts traded has steadily increased with 2009 setting an all-time high of 3.59 billion contracts.
More and more people are now including options in their investments as a smart way to get ahead of the market.
And it's easy to see why.
Advantages
Options afford the investor many advantages, not the least of which is a guaranteed limited risk when buying calls and puts.
And you can also get a great deal of leverage while using only a fraction of the money you would normally put up to get into the actual stocks themselves.
But the real advantage with options is the opportunity to make money if a stock goes up, down or (depending on your strategy) even sideways.
In fact, with some strategies you can even be wrong on the underlying stock's direction and still profit.
All you need to do to increase your odds of success is to avoid some very common (but costly) mistakes, and you can start enjoying all of the benefits that options were designed to give you.
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