I think that it is worth taking a quick step back and first discussing how we value options. If you were to dissect an option’s value into its components then the result would be two parts: Intrinsic Value and Time Value.
Intrinsic Value is the option’s value if exercised on any given day, defined as the difference between the option strike (exercise) price and the price of the underlying asset.
Intrinsic Value (IV) = Price (P) – Strike (X)
For a call option, if IV is positive, then this is the option’s intrinsic value. If the result is not positive, then the option has no intrinsic value. To calculate the IV of a put option, simply reverse the calculation: IV = X – P.
Time value is any other component of option value that is not IV. Pricing time value is complex, however it is easiest to think of it as the value of the future potential price movement. The greater the potential for the price of the underlying asset to move (up or down) and the longer the time to expiration, the greater time value. All things being equal, as an option approaches expiration its time value will decrease and the closer to expiration the more significant this relationship becomes. If you were to plot a graph showing this relationship, then you would see that in the last 30 days or so of an option’s life, the time value drops away rapidly until reaching expiration where the time value of the option equals zero (there is a graph showing this relationship in the ASX Understanding Options pamphlet on page 10).
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So this brings us back to the question- should we buy an option given the above? Generally, it is not recommended. In the last 30 days of the option’s life time decay is working very strongly against your position. So even though the underlying asset may be moving in your favor, the resulting gains in the option may be negated as the time value may be decreasing more rapidly. This is not to say that you can’t ever buy in the final 30 days, you just need to be very sure that the underlying asset is going to move strongly enough in your favor to offset the time decay.
Given the discussion above, selling an option inside the 30 day period seems to be the most logical strategy as time decay is working in your favor. As you would expect, there are many traders who use this strategy, however it comes with very high risk and high margin requirements.
As the seller of an option, you have no rights, only obligations. The buyer of the option can exercise you whenever they choose, regardless of if the option is in or out of the money anytime before expiration (for American options). Theoretically, short calls have the potential for unlimited loss and a short put’s loss is limited to the difference between the strike price and zero. Depending on whether you have sold calls or puts you could be assigned the stock either short (calls) or long (puts).
So for a given receipt of premium the seller takes on significant risk and the resulting margin requirements. In my experience, traders may use this strategy successfully many times over, however it only takes one bad trade to erase all of the profits of the previous winning trades – if not more. So as an outright strategy, I don’t believe it is suitable or appropriate for most investors. However as a vehicle for (potentially) lower cost entry into the underlying asset or coupled with protection to form a spread, it is possible to harness the benefits of time decay and provide viable investment alternatives without the associated risks of a naked option position.
Paul Le Roy, OptionsXpress
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