When it comes to options, you probably understand the basics…
For example, if you think a stock’s going to rise, you buy a call option. A call option typically increases when the value of the underlying stock rises.
And if you think a stock’s going to fall, you buy a put option. A put option should increase when the value of the underlying stock falls.
These fundamentals are a good starting point. But they only form part of the picture… Two more factors can help make or break your trade.
“Time decay” is one factor. Options expire, and as they get closer to expiration, their value erodes faster and faster.
So even if the stock rises, for example, time decay can eat a chunk of your call option’s profits if it doesn’t happen quickly enough.
The other factor is volatility…
The level of volatility when you buy and sell your option plays a big part in determining the success of the trade.
Today, I want to run through a trade we recently did to show both factors at work. So let’s check it out…
Eroding Value
After retracing 16% from its February high, JPMorgan Chase (JPM) was testing support at the $230 level (green line). That was the level it had held and rallied off of back in December.
That big pullback had also pushed the Relative Strength Index (RSI) – a momentum indicator – into oversold territory. That’s below the lower dashed line (at the 30% level) in the bottom half of the chart.
JPMorgan Chase (JPM)
Source: e-Signal
We were looking for JPM to rally off its support level as buying momentum turned higher. So we bought a call option position on March 10 to capture that move.
But as the chart shows, things didn’t initially go our way…
JPM peppered the $230 level for several days before locking in its low on March 13. That coincided with the RSI forming a “V” and rallying from that oversold territory.
The trade then went our way… but it took until March 19 for JPM to break above its March 10 high. By then, we’d lost nine days of time value.
When JPM gapped higher on Monday this week, the RSI was also approaching resistance at the 50% level. So we decided to take our profits. Banking profits when you see them is critical in choppy markets.
We sold our JPM call option on March 24 for a 14.7% gain.
That’s certainly not a bad return in just two weeks. But time decay reduced our overall profit from what it might otherwise have been.
And volatility also played a major part…
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Always Watch Volatility
The CBOE Volatility Index (VIX) measures the expected 30-day volatility of the S&P 500. You’ll often hear it referred to as the market’s “fear index.”
When the VIX is rising, investors and other market players are expecting uncertainty to increase… leading to bigger swings in the market.
When volatility rises, option premiums can get pricier. That’s because higher volatility increases the chance that an option will go “into the money” (and may be exercised). The option seller (or market maker) will want to be compensated for that increased chance.
So higher volatility leads to higher prices… But the opposite also applies.
When the VIX is high but falling, market makers and other players are becoming less concerned about future volatility. That leads to lower premiums.
So in an ideal world, you’d aim to buy an option when volatility is low and sell it when volatility is high. That can give your trade a real boost.
But, of course, in real life, things don’t always line up your way!
CBOE Volatility Index (VIX)
Source: e-Signal
As you can see on the chart, the VIX steadily fell after we entered our JPM trade. That pulled prices lower. And that reduced the size of the premium when it came time to sell our option.
We’re far from complaining about taking a profit of any size, mind you…
But these concepts are vital for understanding why an options trade may or may not succeed… even if the underlying stock moves in the right direction.
Of course, getting the direction right is of primary importance. But it’s not the only thing…
Time decay and volatility can mean the difference between a huge gain… a modest one… or even a loss.
So as traders, we need to keep all three concepts in mind when deciding to open (or close) any of our options positions.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict