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The girls all get prettier at closing time.”
~ Mickey
Gilley ~
Option
trading is not “just the same as stocks.” It turns on the three
primal forces ruling an options trader’s world- time to expiration, price
of the underlying, and implied volatility.
As
expiration approaches, the forces of time exert their strongest influence of
the cycle on a trader’s positions. In today’s blog, written as
August expiration is but a few days away, I want to call attention to some of
the practical considerations traders would be well advised to incorporate
into their trading plan.
Pundits
have long cited the aphorism that there are only two sure things in life-
death and taxes. Options traders must incorporate a third inevitability- the
time component (aka the extrinsic component) of an option premium goes to
zero at the closing bell of options expiration. This occurrence is neither
negotiable nor avoidable and it occurs with clockwork like precision.
A recent
change to the market has introduced an important new element to the long
standing monthly expiration cycle. The tremendous popularity of weekly
options has rendered every Friday the end of an expiration cycle.
It is
critically important to recognize this new phenomenon because it allows
tailoring of strategies to fit more precisely the anticipated time frame in
which the trader’s hypotheses play out.
Let us
consider some of the practical implications of this cyclical pattern. I have
discussed before in this blog the fact that erosion of time premium is not
linear across the life of an option but accelerates dramatically as
expiration approaches. Expiration week is where this acceleration reaches its
greatest pace as it heads to zero at Friday’s closing bell.
What is
often not immediately understood by the new option trader is the radical
change in the risk / reward ratio of a trade produced by this erosion.
Consider a simple one legged trade. A trader who was bullish on AAPL during
the price weakness in late July could have chosen to sell naked puts to
reflect his price view. The graph below shows the trade of selling short the
August 545 strike put at mid day on Thursday July
26 with 23 days to expiration:
AAPL
Option Trading
The trader
would have taken a credit of around $425 for each contract he sold on this
trade with a probability of success of 84%. The trade could have been closed
last Friday for $16/contract locking in $409 per contract less commission.
While the
probability of AAPL trading below the 545 strike as August expiration
approaches is close to 0, it is not O. To accept the risk of a Black Swan
event occurring in order to capture the remaining 3.8% of the initial credit
is not smart trading. The general rule-of-thumb I follow in this type of
trade is to close or roll up the position to a higher strike when 80% of the
initial credit received has been captured.
Perhaps
the most nuanced effect of time to expiration is seen in the behavior of the
butterfly trade construction. To review briefly, remember that the classic
butterfly is constructed in either calls or puts and consists of both a debit
and a credit spread which share the same short strike.
Butterfly
positions have the interesting characteristics of responding only minimally
if at all to price movement when far out in time from expiration. These same
trade structures will react violently to price movement when little time to
expiration remains.
An example
could be constructed during the July AAPL price rout. Let us assume a trader
was sufficiently prescient to predict the price recovery. In order to capture
this hypothesized movement, he could have purchased the August 605/-625/645
in a (+1/-2/+1 standard butterfly ratio) call butterfly spread on July 26th.
This trade structure is a defined risk position where the maximum risk is the
cost of entering the position.
This
position would have been very inexpensive because of two factors:
1. Implied
volatility was elevated, rendering the butterfly cheap.
2. The
center strike where the options were sold short and the point of the
theoretical maximum profitability had less than a 5% chance of being
in-the-money.
The
P&L graph for this position at the time of entry is presented below:
AAPL
– Apple Option Trading
Several
practical points bear emphasis. First, the maximum potential profit from this
low probability trade is in excess of 1800%. This trade construction which
cost around $100 per spread at the time could have been closed last Friday
for a profit of over $850 per spread.
Second and
the point germane to today’s discussion is the behavior of the trade
with regard to time. Notice that the broken lines, representing intermediate
time points in the trade achieve nowhere near the full profit potential that
exists when expiration arrives.
However,
not to be missed is the fact that the range of profitability narrows
dramatically as expiration is approached. It is for this reason that most
experienced butterfly traders remove profitable trades before their wild
relationship to price is activated as expiration gets quite close.
I want to
be very clear about this demonstrated butterfly trade. This is not a typical
trade I would enter because of its low probability of success. I present it
as a purely educational exercise to demonstrate the behavior of these
frequently encountered trade structures.
I invite
you to try my service to follow my trades and understand how the nuanced
behavior of options can be used to deliver highly profitable trades.
Happy
Trading!
JW
Jones
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