We talked about how time is money options traders earlier but the longer an option has (number of days) until it expires the more it will cost. This is logical because in the previous example with an option to buy a house, if the seller had given you a two-year option to buy the house he would want more money for it than if he only sold you a twelve-month option. The reason being is the longer the option has until expiration; the more risk the seller has. More risk = higher cost. There is option trading software that will help calculate this for you but for now just remember what I said about time being worth money.
In figure 1.1, an option with 180 days left until it expires is worth much more than an option with only 30 days left until expiration. This “value” only has to do with the time value of the option. It has nothing to do with the strike price of the option which we will discuss on the next few pages. Remember that the first part of this blog is written to help teach options trading for beginners. Later articles in this blog are going to teach you how to learn to trade options for a living.
The last thirty days of an option’s life, the value of the option deteriorates quickly because people don’t think that it will gain much in value during that time.
Options Are A Depreciating Asset
Options have what is referred to as “time decay”. All this means is that as time goes forward all options lose time value. Remember one of the things that makes up the value of an option is how much time it has until expiration. This can be a major part of the price you have to pay. Like they say, “time is money”, especially in options.
Let’s use an example of buying a Call option in Sugar and we will say that Sugar is currently trading at about 12.00 cents. We are Bullish the market and think that sugar will go to 14.00 in the next couple of months. Let’s also say the front month in the futures market is the March contract.
In the following chart, figure 1.2, you can see the cost (premium) of a 14.00 Call is $134.40 and gives you the right to be long sugar from 14.00. Since Sugar is trading below the strike price then the entire premium is for extrinsic, or time value. Since it is “out-of-the-money” (above the strike price) it has no intrinsic or real money value.
The person who is selling this option is betting that Sugar will not go to 14.00 in the next 53 days and that this option will expire worthless. Actually it would have to go a little higher than 14.00 for him to lose money since he collected a premium for selling it. So the option seller’s breakeven is 14.00 plus what he collected in premium. We will talk much more about this later on. For taking this risk, he wants to be paid $134.00. So these 53 days of time value will cost you $134.00. Options usually expire about 30 days before the futures contract expires.
Now what if you wanted more time thinking that sugar will indeed go up to 14.00 cents but it might take longer than 53 days. Well, you will have to buy an option in a further out contract month. Look at Figure 1.3 which is the May contract, the next contract month out.
The May contract with a strike price of 14.00 cost almost twice as much ($257.50) as the March contract with a 14.00 strike price. The reason is the May option has 97 trading days until expiration whereas the March option only has 53 trading days until it expires. Again, time is money and the option seller wants more money because he is taking a greater risk by giving you more time. The additional risk he is taking is that he is selling you an option with 97 days left rather than 53 days left until the option expires.
In, Out & At-The-Money
You are going to hear the terms, Out-of-the-money, At-The-Money and In-the-money throughout this course so I guess this is a good time to give you some examples on a chart. Look at Figure 1.4 where I show you what these terms mean.
In this example, there are three lines drawn at three different strike prices. When you buy a call option the seller is agreeing to allow you to be long a futures contract from whatever strike price you bought.
If you purchased the 103.00 Strike Price for $2,175 then you could be long a futures contract from 103.00 which is under the current closing price of 104.950. So this option has $975 of Intrinsic Value (real money value) since you would be long from 103.00. The balance of the premium you pay ($1,200) is for Extrinsic Value (time value). Since the option has Intrinsic Value then it’s called “In-the-money”. The reason being if you converted it to an Futures contract today, then it would be worth $975. A Call option is In-the-money anytime the Strike Price is below where the price the futures market is trading.
While I’m thinking about it you should never exercise an in-the-money Option to a futures contract that has time value remaining because once you convert it (exercise it) you will lose the remaining time value.
If you purchased the 105.00 Strike Price for $1,525 the option has almost no Intrinsic value, only Extrinsic Value, so the entire premium is for its “time value”. If it’s at, or near, the current futures price, it’s called “At-The-Money”.
An At-The-Money option can have either a small amount of Intrinsic Value (if it’s just below the futures price) or no intrinsic value (if it’s exactly at, or just above the futures price). At-The-Money simply means the strike price is close to the futures closing price that day.
The 107.00 Strike Price costs $1,012.50 and is above the futures price so it is called “Out-of-the-money” and it has no Intrinsic value, only time value. So the entire premium is for time value. The closer the strike price is to the current futures price, the more it costs and the further away it is the less it cost.
The 121.00 Strike Price (not shown on chart) only costs $12.50 and is “Deep Out-of-the-money” and has little chance of ever being “In-the-money”. Usually you want to stay far away from buying any “Deep Out-of-the-money” Options. And yes, they are cheap but there is a reason they are cheap and it’s because they almost never make any money for the buyer. And they don’t have enough premium involved to sell them and they are extremely illiquid. Just do yourself a favor and stay away from them (Think Cheap Options = Chump Option (most of the time)). In fact, anytime you buy or sell an option always check the open interest in the futures market. You want to be in as liquid a market as possible if you need to make a quick exit! This is another area where a full service broker pays for himself many times over.
Puts work exactly the same way as Calls, just reversed. We will be looking at a lot of charts with Puts on them in the course but I will show you a chart with Puts on it at various strike prices. See figure 1.5.
Starting at the top, you see the 92.00 call is In-the-money and has both intrinsic value and time value. It’s the most expensive of the four because of how much intrinsic value it has.
The second Put is at 91.00 and it’s at-the-money because it’s close to the future closing price that day.
The third Put is at 90.00 and is out-of-the-money because it’s below the futures price.
The bottom strike price of 86.00 is deep-out-of-the-money and should not be purchased.
Also, you will hear terms of being short a Call or long a Put. Sound crazy but what it means is that if you are short a Call, you sold a Call and if you are short a Put, you sold a Put. And if you are long a Call, you bought a Call and if you are long a Put you bought a Put. An easy way to remember this is that if you sell an option, either a Put or a Call, you are short that Put or Call and if you buy either a Put or a Call you are long that Put or Call.
Let’s say you bought a December 2006 Sugar call in June with a strike price of 12.00 for $500 and it expires in November (options always expire before the futures contract ends). Well you would have about six months of time value left. Now if the futures market was trading at 10.00 when you bought it, the option is out-of-the-money, or in other words it has zero intrinsic value. So the entire $500 is for time value. Intrinsic value simply means that if the option was converted into a futures contract right now, would it be worth anything? So if you had a 12-cent call option in Sugar and the market was trading at 10 cents then your option has no intrinsic value.
Even if the price of the futures market goes up to or even past 12.00 before it expires, it’s not necessarily going to be worth more than you paid for it. Remember the entire premium was for time value. So if the futures price went to say 12.25 at option expatriation you would have zero time value left and your option would only be in-the-money (intrinsic value) by .25. Since a full cent move in sugar is worth $1,120 then your option is only $280 in-the-money with no time value left. You would have a loss of $220 on the option that you paid $500 for ($500 - $280 = $220), and not only did the futures market go up as you expected, but the option was also "in-the-money" at expiration."
You have to learn to buy the right options, at the right time for the right price. By the time you finish this course, you should have a good handle on doing this. So don’t forget – Time is Money Options Traders!
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