noob question. why does all this matter if the values will be different tomorrow? also why is time decay important if I'm right about timing and direction. if xyz stock is at 20, and i buy a 25 call that expires in 3 days, compared to a 25 call that expires in a month. If xyz reaches 25 in the 3 days, why buy one with more time attached? thanks
Cashmoney, don't take this the wrong way, but I'm glad you admited you're a newbie In the example you gave, believe it or not, you could lose 100% of your money! You say the 25 call expires in 3 days, and xyz hits 25 in 3 days - if it's just 25 at the end of the day, it is basically worthless! The call with a month to go would still have value and would probably show a very nice gain at this point! If you could go into the future and know XYZ would be 25 in 3 days, you would buy the shortest term 20 or 22.5 calls possible, but laking having a time machine, you might want to have more time for your position to work. How would you feel if you bought this option and then in 3 days XYZ was $24 and you had a 100% loss and over the next week it goes to $30? Also, you asked "why is time decay important if I'm right about timing and direction.". If you were always exactly right about timing and direction, you could make a fortune trading options and probably stocks for that matter. The problem is that a person might be correct about direction, but not timing. Let's say a stock XYZ is at 71 and you buy an 80 call with 3 months to go for $250. If XYZ moves up very slowly it might be at say $75 with a month to go and the call might be say $150. Now, it moves slowly to $79.00 with a day to go - the call might now be $75 or something. Now, it moves to $79.75 with 10 minutes left and the call is worth $10 and ends up a 100% loss. In the example above, you took a 100% loss, but who could have made money? Most likely people who bought 3 month out 70 and 75 strike calls (and 65 for that matter) and quite possibly people who bought 80 or even 85 strike calls 6 months or further out (depending on what the IV was at the time of purchase, and what it is now). JJacksET4
Well, if you know the exact day and hour that the stock will move - and how much it will move - then you can wait until just before the move begins and buy the option then. But those of us who are not quite so astute may have trouble being that precise. I may have a strong belief that xyz will go up over 25, but I don't really know when. If I buy a 25 call with 30 days remaining, I have a better chance of catching a 5-point move than if I buy one with just 3 days remaining. If I buy a call with 6 months remaining, I have a better chance still. Of course, I pay for that "better chance" by paying more for the option. That's the trade-off.
thanks jj and DMO. To summarize, its best to buy more time than is needed, even though it may cost more up front, but its better than losing 100% of the investment. side note: i like april 125 aapl calls.
and prepackage option strategies into neat little rules is not advisable. It all depends on the iv levels, the diff of iv between months,etc. In that example the nearest option with 3 hours to expire would have the highest gamma so if the stock moves from 23.5 to 25.5 in 2.5 hours, your ATM fornt month option will explode in value vs the far out months. however, once the stock retraces form 25 to 24.75 with only 1o min to go, it will deflate as rapidly. so it really depends on the magnitude of the move as well as the time frame. The Iv levels are so high now that buying back months is a risky trade.
Is it better to buy more time in order to reduce the probability of losing 100%? Maybe yes and maybe no. That decision is the whole art if you're buying options to play the direction of the underlying stock. That's one reason you want to become very conversant with implied volatility, which tells you how much you're paying for that time. It gives you a framework to understand if you're paying a high price or a low price for time.
I had an epiphany last night, when thinking about a more effective way to estimate time and price in a stock, before trading the option..here is what i came up with. go out to a monthly chart, and subtract the high from the low, and do that for at least the next 3 monthly bars. The number you get after your subtraction from the H-L of each month then is averaged by the number of months you looked at. for example, here is aapl for the last 9 months with the highs and lows already subtracted feb --> 21.15 mar --> 27.74 apr --> 36.39 may --> 20.24 june --> 25.80 july --> 34.38 aug --> 27.54 sept --> 73.41 oct --> 31.40 * take the numbers from all 9 months and average them, and you'll see that aapl will move an average of 36.74 points a month, or 9.18 pts a week. so on my jan 125 aapl call i mentioned in a previous post, I have just shy of 2 months to go 29.10 pts. If the average rise/fall of aapl stock is 36.74 month, then the odds should be in my favor. looking at aapl for this month, the open was 91.30..add 36.74, and aapl should be at 128.04, or down to 54.56.
Your epiphany is in seeing for yourself the importance of volatility to the value of an option - the higher the volatility, the higher the probable value of the option at expiration and, therefore, the higher its value now. To deepen your epiphany, you could look into some different ways of calculating volatility. You did it monthly; it can also be done weekly or daily. There are other possible variations too - for example, you can use the high and low of each bar, or the distance from one close to the next. The "correct" volatility to use in evaluating an option is the one that will exist between now and expiration. But since no one knows what that will be, one way to estimate is to use past volatility, as you did.