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Keeping up with the value of an option can be challenging. You’ve got the intrinsic value, which changes as the stock’s market value changes, and you have extrinsic value, which at first seems to change mysteriously and unpredictably. In this post, we’re going to get into the weeds and try to demystify the changes you see in extrinsic value by looking at the factors that affect extrinsic value: time until expiration, price of the underlying, and volatility. First, let’s look at the option chain for a contract expiring on Friday of this week. We’ll look at Amazon this time and our chart now displays a different set of columns, because we will focus on the Theo Price:
AMZN 26 August 2022 Option Chain captured on 8-21-22
The Theo (short for theoretical) Price is a tool we can use to estimate how changes in time until expiration, underlying price, and volatility will affect the market price of an option contract. Because the settings for Theo Price are all set to the current date of this writing, the current price of the underlying, and the current volatility, the Theo Price is simply the average of the bid and ask prices.
First, let’s experiment with the time till expiration by moving the calendar one day, to 8/22/2022.
Theo Price 8-22-22
Check out the 137 strike. The Theo Price on 21 August was $3.28. One day later, it is 2.97. The table below lists the Theo Price for each day of the coming week:
Date
Theo Price
Change From Previous Day
% Change
8-22
2.97
-0.32
-9.75
8-23
2.63
-0.34
-11.45
8-24
2.24
-0.39
-14.83
8-25
1.21
-1.03
-45.98
8-26
0.92
-0.92
-76.03
Change in Theo Price Over Time
The Theo price changes increasingly rapidly as expiration approaches. This is what traders are talking about when they speak of time decay. Another term they will often use is theta (Θ), the Greek letter which equates with the Latin letter ‘T.’
Next, let’s see how changes in volatility affect option prices. We’ll use today’s date and price, but contrast how increases and decreases in volatility affect the Theo Price. I’ll not post a screen capture. If you’re still interested in options, you might want to download a trading platform and try to learn how to perform this sort of analysis yourself.
Volatility Change
Theo Price
+1%
$3.34
-1%
$3.21
+5%
$3.60
-5%
$2.95
+10%
$3,93
-10%
$2.62
Changes in Volatility and Theo Price
We will discuss volatility at length in future posts. We will defer on discussing how we might use changes in the underlying price to help in trade selection and management. For now, the take-away is that option prices fall as volatility falls and as expiration approaches.
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Last week we tracked an imaginary ITM long call at a strike price of 170 with a DTE of 19 AUG 22. In trader shorthand we might identify the contract as .AAPL220819C170. That’s the symbol we used at the end of the previous post to track how the option’s price moved. Here’s a reposting of that chart:
.AAPL220819C170 Y-axis starts at 6/1/22, ends at 8/19/22 The candles show daily movement and the purple line tracks the price of the underlying (AAPL)
At expiration the call was ITM (in the money) because the underlying stock’s price was greater than the strike price. When the price of the underlying exceeds the strike price of a call, we can say that the call has intrinsic value. If the strike price of a call is greater than the price of the underlying, the call has no intrinsic value. Our imaginary trade last week still had some intrinsic value (and only intrinsic value), which is what we would have realized when it was automatically exercised. Unfortunately, the price we paid for the contract exceeded its residual intrinsic value at expiration.
Prior to expiration the contract held extrinsic value as well as intrinsic value. Intrinsic value varies as the underlying price changes. Extrinsic value varies as multiple other factors change. Primary among those other factors is time until expiration. Extrinsic value decreases at an increasingly rapid rate as the expiration date approaches. You might recall last week, that if our imaginary trade were a real trade, I’d have closed the call on Wednesday or Thursday morning and taken a profit. Knowing how quickly extrinsic value erodes in the days just prior to expiration strongly informed the timing of my decision to close the trade.
A little more about intrinsic and extrinsic value. If the price of an underlying stock remains the same, its intrinsic value will also remain the same. Examine this capture of the option chain for Amazon (AMZN) and note that the intrinsic value of the options remains constant across all of the expiration dates listed:
Intrinsic and Extrinsic Values of Options
Unlike the intrinsic values, the extrinsic values are greater for options that are further into the future. You’ll hear people say that you can’t predict the stock market, but there’s a major exception to this rule: as sure as the amount of daylight decreases between the summer solstice and the winter solstice, so too will extrinsic value decrease. This is a simple truth that successful traders use to great advantage.
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In option trading, a call is a type of contract. Traders can buy calls, which give them the right for a specified amount of time to buy stock at a specified price. The price specified for the stock is the strike price. The time that the contract is in force is described by its expiration date or DTE. The published cost of buying the call contract is the Ask price. The image below is a screen capture of the option chain for Apple (AAPL) made on Sunday afternoon, August 14, 2022, which is when I began composing this post. At the time of the capture the last trade price for AAPL during normal trading hours was $172.10 per share. However, there had been some afterhours trading that sent the bid and ask prices for the stock (not the options) to $171.85 and $171.90 respectively. This information can be retrieved by looking at the area enclosed by a red rectangle. Further below in the image you’ll see a green rectangle that contains information about a call contract with a strike price of $170 and an expiration date of August 19, 2022. The two rightmost columns display the bid and ask prices for this option contract. The ask price is the cost per share associated with this contract. The contract itself bundles 100 shares, so the price of the contract would be $335. Depending on your broker, a fee will be added. TD Ameritrade charges 65 cents per contract, so the total price of the trade would be $335.65. We’re going to do a little thought experiment now and see what might happen if we bought the 170 call, and then we’ll compare those results with what might happen had we simply invested in AAPL stock directly. I’ll use actual data and complete composing this post over the life of the option.
AAPL Sunday, August 14, 2022 Captured from Thinkorswim
Now take a look at AAPL’s option chain at mid-day Wednesday, August 17,2022, which is when I wrote the following section of this post.
AAPL Wednesday August 17, 2022 Captured from Thinkorswim
Mid-day on Wednesday AAPL’s bid price (what it can be sold for is now $173.38. We also see that its high so far on Wednesday is $174.45. The bid price for the 170 strike has risen to $3.80.
Let’s consider a couple scenarios for our imaginary trade. If we closed the trade by selling the $170 option for $3.80, we’d realize a profit of $0.45 per share. Since the contract was for 100 shares, our total profit would be $45 minus fees of $1.30 (65 cents for each of our two transactions). Net profit would be $43.70).
Let’s analyze our resulting profit a bit more. The total risk we assumed before applying fees was $335. If we divide our gain before applying fees by this amount we have: 45 / 335 = .1343 or 13.43%. We earned this gain over three days. Anualized, the gain would approximate 1634%, a stunning return.
Now, let’s examine a second scenario. Say we simply bought a hundred shares of AAPL for $171.90 per share, when that was its price. We would be investing (i.e. risking) $17,190. If we sold that stock on Wednesday at $174.45 per share, we would be paid 17,445 for that sale, a profit of $190.00. How can we measure the percentage return on risk in a stock purchase like this one? By convention, we’d divide our return (190) by our purchase price ($17,190) and be happy with 1.1% return over the three-day period. Realistically, we know, though, that our risk was really much less than $17,190 because the likelihood that AAPL shares would fall to zero is infinitismally small. We can, however, estimate our risk by looking at how AAPL share prices vary in the past. There are many statistical ways to make this estimate, and as new traders become old traders, they develop preferences for how they make such estimates.
An important take-away: Options can be a very efficient use of capital.
Now, it’s Thursday. About 24 hours has passed since my last update to this post. It’s 11:34 ET. Last price for AAPL is $174.66. The 170 strike can be sold for $4.70. You know how to do the math to calculate our profit/loss depending on whether we exercise the option or close it. Tomorrow is the expiration date for our option. So far, we haven’t considered what will happen at expiration. That depends entirely on what AAPL is trading at when trades are settled after the market closes. If the the closing price of AAPL is less than $170, the option will expire worthless. You will have lost your opportunity to close the trade at a profit. If AAPL trades above 170, it will automatically be excercised unless you tell your broker ahead of time that you don’t want it exercised. When the option is automatically excercised, you have just bought 100 shares of AAPL for $170 a share. If you don’t have $17,000 available in your account, you’ll have to free up that amount either by liquidating other holdings or depositing more money. You can also sell your stock after the market reopens on Monday for whatever the trading price is then. You might win some money or you might lose some money. The vast majority of traders will close their option trades before expiration to avoid the uncertainties associated with expiration. We will explore these uncertainties in greater detail in later posts.
So what should be done today? Nothing? Exercise? Close the trade with a $90 profit? I’m not going to recommend a path, but I’ll tell you what I would do and why I would do it. I’d close the trade and be satisfied with the profit. I would not excersize the option because I don’t want to tie up $17,000 in AAPL stock. I would be happy to have $90 by closing the trade and eliminating the worry going into tomorrow.
Today is Friday, August 19, 2022. When the market closes this afternoon, those holding this trade will have no more control over it. The value of our option contract will go to zero. If AAPL remains above $170, we will become the owners of 100 shares of the stock. Our total cost for those shares will be 17,000 plus the $335 we paid for the option contract plus the 65 cent fee we paid to open the contract: $17,335.65. Last night AAPL closed at $173.75. At 10:56 ET this morning it’s trading at $171.86. We could buy back our option contract for $355, a loss of $20 for the trade. To break even on excercising the option (without considering the 65 cent fee for opening the contract), AAPL would have to trade at 173.35 (170 + 3.35).
Not to be smug, I would have closed the option yesterday, and walked away with 90 dollars. We should think seriously about getting out of the trade before it expires, else we cast our fate to the wind. I’ll report AAPL’s close after market tonight.
August 19, 2022, after market close. AAPL closed out the week at $171.55. Had we kept our trade open through expiration, we would expect our option to be automatically exercised for $170 a share (17,000). We could sell those one hundred shares after the market reopens next week. We don’t know for sure what the price of AAPL will be then. If it stays put, we will have lost $180.65:
Cost of 170 call option
$335.00
Transaction fee
$000.65
Value of 100 shares at expiration
$17155.00
Net
-$180.65
Calculating P/L
Finallly, let’s look at the chart that records the option’s price swings.
AAPL220819C170 Y-axis is day starting at 6/1/22, ending at 8/19/22 The candles show daily movement, and the purple line tracks the price of the underlying (AAPL)
The chart was captured at closing, so the rightmost candle’s closing price is composed only of intrinsic value; that is, the difference between the strike price and the price of the underlying stock. In a future post we’ll examine in greater detail both intrinsic value and this chart.
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Options are a type of derivative. That is, their value derives from another financial instrument. If you buy an option on AAPL stock, for example, the value of the option depends primarily on the price of AAPL stock. Many, maybe most, option traders begin their careers by buying stock. A strong understanding of the stock market in invaluable to the option trader. When you buy a stock, you actually own a piece of something, typically a share in a business, though you could also buy into a fund (an ETF) that contains a collection of stocks. When you buy shares in a company, you tie a part of your financial well-being to the fortunes of that company. You hope that the company is profitable, and you expect that your investment will appreciate as the company moves forward. But you also know that businesses have to assume certain risks that have the potential to depress the market price of their shares. The market price of a share of a company reflects the consensus judgment of a company’s value made by investors who consider a variety of factors. Just a few of these are the company’s profitability, its growth potential, its product line, the talent pool it draws on, its record on paying dividends, and external factors. The market price reflects a crowd-sourced opinion of what the company is worth. When you buy a share of AAPL, you are acting on an opinion that the current market consensus on the price of its stock is low and you expect it to rise. When you sell your shares, you are acting on an opinion that the market has over-valued the stock and that its price is likely to fall. The gain you can achieve by holding stock depends on the dividends you receive and any increase in the share price. Your risk is equal to the equity you hold in the stock. The worst case is if the stock price were to descend to 0. That’s unlikely, but individual stock issues can become highly volatile and experience considerable gains and losses. An extreme example of volatility can be seen in Gamestop (GME). The chart of its pricing between early 2021 and summer 2022 tells its story.
GME weekly chart 3-29-20 through 8-15-22
I know young traders who made and then lost tens of thousands of dollars buying and selling Gamestop. Many bought at precisely the wrong time, and never regained their full loss. Others, of course, sold at the top and walked away with fortunes. What motivated those who bought at the top and those who sold at the top? Let me suggest that retail traders who bought at the top were motivated by greed. Those who sold were motivated by fear–fear of losing gains they’d achieved. All traders experience greed and fear. Successful traders need to be able to rationalize those emotions; that is, they need to unemotionally consider data that can justify actions to satisfy greed, or to respond sensibly to fear. Such data can also come from the price chart. Earlier I wrote that market price reflects a consensus of what a share is worth. Individual traders may think the stock is worth more, others less, but the market at large makes the final judgment. You may have noticed that as we closed in on 2022, Gamestop’s price began to vary between $20 and $50 per share. That’s still a pretty broad range, but these parameters tell us something about those trading GME. When they see the price heading towards $50, as a group, they become fearful and begin to sell their holdings. Conversely, when shares fall towards $20, they see an attractive price offering a good opportunity for profit. These levels of support and resistence can become objective data that inform your decisions on buying or selling stock. They will also play an important role in option trading.
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A profit machine for trading options has a lot of moving parts. The first challenge new traders face is getting their heads around the fundamentals of how option contracts work. You can find a lot of places online that explain the basics of calls and puts, option spreads, and how options are priced. A lot of it will seem impenetrable. I found that the best written and most accurate information was available online through my brokerage account. Although I’m not going to recommend any particular brokerage firm or information source, I will share the sources that helped me get the basics, and I will list them in the sidebar of this blog. I opened an account at TD Ameritrade, where I continue to explore lessons, articles, and webcasts. Even without a TD Ameritrade account, you can view their webcasts. I used $50 dollars to open an account there, and gained access to a lot more–data, interactive courses, and their trading platform Thinkorswim(TOS). I loaded TOS on my PC, and discovered a bewildering, but powerful, application that supports live trading with real money as well as pretend trading, which they call a paper account. Although I’ve used TOS for over a year, I still learn new things about what it can do. Learning to use a trading platform is important, but there’s a lot more to trading options than just pointing and clicking. Still pointing and clicking is where I began. Another resource I used was Investopedia, which has many understandable articles on various aspects of trading. I also learned from Option Alpha, which offers a very specific approach to trading options that is worth consideration. In the end though, as I learned more about how option pricing works and became more knowledgeable about the underlying stocks and exchanges traded funds (ETFs), I developed my own unique approach.
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I’m not ready to stop learning. So here I am, an old dog trying to learn new tricks. The tricks that engage me these days are trading tricks, specifically trading stock options. I began my study in earnest at the beginning of 2022. The S&P 500 was at an all-time high. We didn’t know that it would begin a significant decline, that inflation fears would coalesce, that the bears would soon be snarling. I knew that options trading could be profitable in down- as well up-trending markets, and I was transfixed at the thought that I could be successful no matter what direction the market took. Here, in this blog, I’ll write about what I’ve learned, my successes, and my failures in the path I’ve taken to learn how to trade options successfully.
