One of the most interesting
aspects of options is the myriad opportunities presented for high probability
trades for those who understand the details of option behavior.
For example, I have recently
discussed the routinely observed collapse of implied volatility immediately
following an earnings release. We have looked at several examples of
profitable trades constructed to benefit from this expected decline in
implied volatility.
Today I would like to review
another group of trades based on a fundamental characteristic of option
pricing. In order to understand this phenomenon, we need to review briefly
the anatomy of the price of an option.
Remember that an option's
price, while quoted as a pair of bid / ask values, is in reality the sum of
two components. The current market price is the combination of the extrinsic
and intrinsic components of the individual option contract.
The extrinsic component can
comprise the entirety or only a variable portion of the market price of an
option. All options contain at least a small amount of extrinsic component.
The intrinsic component of an
option may comprise the majority of the value of an option, as for example a
deep in-the-money option. Conversely, an individual out-of-the-money option
routinely contains no intrinsic value whatsoever.
As an example, consider two
current option prices from the AAPL option chain as the price of the stock is
around $450. The deep in-the-money March 400 call is priced at $54; it
consists of $50 of intrinsic premium and $4 of extrinsic premium. In
contrast, the out-of-the-money March 500 call is priced at $2.60. It contains
$0 of intrinsic value and $2.60 of extrinsic premium, or the entire price of
the option.
One important consistent
observation on the ratio of these premiums should never be forgotten because
it is invaluable to remember in constructing potential trades. The
at-the-money option contains the most intrinsic premium within any one
expiration series. This occurs 100% of the time or ALWAYS.
Another important point to
realize, another characteristic about which there is no argument, is that the
extrinsic premium goes to essentially 0 at expiration. Furthermore, there is
a rapidly accelerating decline to 0 as the expiration date approaches.
My mental analogy is that the
extrinsic premium is like a snowball rolling downhill; it starts slowly,
gains mass, and rapidly accelerates as the end of the slope (the expiration
date) approaches.
While in previous times this
vanishing of extrinsic premium was confined to a single monthly cycle, the
recent advent of weekly option cycles has come to mean this is a weekly
event. The final smell of burning extrinsic option premium as it goes to 0
occurs every Friday for the most active issues!
The logical extension of this
daily decay of extrinsic premium has a practical implication every Friday
morning. Extrinsic premium that is present for options series expiring that
day will go to 0 by the closing bell. Read that again! This weekly occurrence
has great profit potential for your trading.
As an example of the power of
this mandatory decay, let us consider last week's closing action in the XOM
weekly option series. As we have discussed before, XOM has a hugely active
options series, trades in both monthly and weekly expiration series, and has
bid / ask spreads that are just a few pennies wide. It is, in short, close to
an ideal option trading candidate.
XOM reported earnings shortly
before market open on Friday, February 1st. The stock initially sold off to
$89.40 from its previous close at $90.24. Shortly following this bottom, the
stock manifest an intraday rally and the option activity was tightly focused
within the first hour of market activity at the 90 strike options which were
to expire that day.
02/01 XOM Intraday Price Chart
02/01 XOM
Option Chain
This strong, clear, and tight
focus of options activity was a highly predictive factor that XOM would
"pin" the 90 strike for the day.
At the time that XOM was
slightly below $90 and the extrinsic premium existing in the 90 strike puts
contained an extrinsic value of $0.28 and a total price of $0.32. I sold the
90 puts with only a few hours of life remaining until expiration. Within a few
hours, XOM traded to a few cents above $90 and I was able to close these puts
for $0.12.
This highly successful trade
benefitted from both the resurgence in price correctly predicted earlier by
the tightly focused options activity at a single strike price and by the
relentless decay in extrinsic premium toward 0 as the expiration bell
approached.
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