Stocks are looking to close the week on a positive note, as the S&P 500 is pushing for its 7th straight winning day. The strong momentum in stocks has recently been attributed to renewed hopes that the U.S. and China will come to terms on a trade deal.
Now, some traders might be complaining because of the lack of volatility in the market. But today is actually one of my favorite days to trade.
Why?
Because it’s expiration Friday.
You see, most popular stocks and options offer weekly options to trade, that expire every Friday. That said, on expiration day, an option will either expire worthless or in-the-money, there is no in-between.
Furthermore, options are time wasting assets. That means on Friday’s you can find options for dirt cheap… because there is a high probability that they will expire worthless…
…but when they don’t…
Profits are explosive.
For example, last week I decided to day trade options on BABA and SPY, based on what my money indicator was telling me. That said, this is what I wrote to WMM clients in advance:
(You can day trade options, and Friday’s happen to be the best days to trade them )
Well…
It couldn’t have worked out any better…
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Not too shabby…39% on 68 basis points in SPY calls…
And that’s the thing. Options are priced on a probability model. Furthermore, options that are at-the-money (and out-the-money) can lose premium quickly on expiration Friday.
And one of my strategies is to find these high risk-reward trades…because the payouts can be so insane.
However, since you’re getting incredible leverage, and the risk is already high, I just put the tiniest fraction of my portfolio in these types of trades.
That said, to get a deeper understanding of how options move on expiration Friday, I put together this lesson on options time decay, read on to learn more.
Why You Need to Understand Time Decay
When you’re trading options… there’s one factor that can either hurt or help you… and that’s time decay.
You see, time matters when you’re trading options. If you don’t already know, when you buy options, there’s an expiration date. For example, if you buy options today, and they expire in 30 days… then the time to expiration – or days to expiration (DTE) – would be 30 days. As time passes, those options would lose “time value”.
Think about it like this… when you buy milk, it has an expiration date. As the days get closer to the expiration date… you’re losing a bit every day (assuming you don’t drink all the milk before that date).
When you’re long options… time decay can hurt you.
For example, let’s assume you’re long $205 strike price call options in Apple (AAPL) expiring in one week… the stock is currently trading around $196. On the other hand, let’s say you bought the same strike price options, but this time you the expiration date is in three months.
Without even really knowing about the intricacies of options, you could probably guess that the options expiring in three months would be more expensive.
You see, Apple’s price will have more time to fluctuate for the longer-dated options,when compared to the ones expiring next week. Theoretically, that would increase AAPL’s potential price range.
As those options expiring one week approach the expiration date… the stock will lose value faster… and the closer it gets to the expiration date… the faster those options lose time value.
That’s what we call time decay, or theta decay.
Theta Explained
This is where the option Greeks come into play. Option premiums are comprised of intrinsic and extrinsic value. We’re going to be focused on extrinsic value here. The extrinsic value is the time factor and probability in the option value.
Now, one of the option Greeks is theta… theta tells us how sensitive an option’s price is in relation to time. In other words, theta lets us know how much a specific option gains or loses per day as time passes.
Remember, when you’re long options theta decay will cause those options to lose value. On the other hand, when you’re short options, theta decay will actually help your profit and losses (PnL).
You see, when you’re short options, whether it be calls or puts, you want those options to lose value. Option premiums lose value over the life of the contract… and that’s why I like to short options some times.
Here’s a look at how time decay works.
If you look at this graph above, time decay accelerates as you get closer to the expiration date.
Now, let’s get into the specifics of how theta works.
Let’s say $175 strike price Facebook (FB) call options expire one week from today… and those options have a theta of -0.10. Assume the stock is trading at $175. If you buy those options, then they will lose $0.10 of premium tomorrow. Keep in mind, theta is not a constant number, as you can see from the graph above.
On the other hand, if you decide to short those call options… you would be gaining $0.10.
Key Takeaways
- Long calls and puts have a negative theta.
- When you’re long options, theta decay will negatively affect your PnL.
- Short calls and puts have a positive theta.
- When you’re short options, theta decay will positively affect your PnL.
- Options with a longer time to expiration are less sensitive to time decay. Shorter-dated options are susceptible to time decay.
You might be wondering, “Jeff, how can I put this into action and make money from theta decay?”
Basically, shorting options on expiration Friday makes sense. Again, on expiration Fridays, options will either expire in the money… or worthless. However, there is still some time premium left. As the trading day gets closer to 4:00 PM EST on expiration Fridays… the time decay accelerates… and that’s when you can make money from time decay. Keep in mind, some options expire at 4:15 PM EST (like SPDR S&P 500 ETF (SPY) options).
Lastly, if you’d like to learn more, check out this article I wrote for Raging Bull about the option Greeks.
Source: WeeklyMoneyMultiplier.com | Original Link
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