Wednesday, July 18, 2012

The Passage of Time Leads to Profitability for Option Traders

From J.W. Jones at Options Trading Signals.......

J.W may not be talking crude oil today but we never miss a chance to hear what he is thinking about using options to play this market.

My most recent missive discussed some of the nuances of the options Greek, Delta which deals with the change in option price with regard to changes in price of the underlying. Today I would like to examine some of the practical details surrounding the second of the primal forces describing the behavior of options with regard to the passage of time. This second Greek is Theta.

As opposed to the value of a stock position which varies only in relation to changes in price, options are subject to changes in value as a result of the interplay of three factors: price of the underlying, time to expiration, and implied volatility.

Before we delve into describing the operational characteristics of Theta, we need to talk about the anatomy of an options price. Although it is quoted as a single bid / ask pair of quotes, the options price reflected on your quote screen actually consists of the sum of two components – the extrinsic and the intrinsic value of the option in question.

The intrinsic value of an option is that portion of the option that has value by virtue of the current stock price. For example, AAPL currently trades around $607 / share as I write this. The August 600 strike call trades at around $27.00. The intrinsic value portion of that premium is ($607-$600 = $7).

Intrinsic values of a given option can vary from essentially the entirety of the option value for a "deep in the money" option to $0 for an "out of the money option". In our AAPL example, the "out of the money" strike of $610 sells for $22 and contains $0 of intrinsic value.

Read the entire article > The Passage of Time Leads to Profitability for Option Traders

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