Option Investor
Educational Article

How Trading Options Resembles Flipping Houses in a Declining Market

HAVING TROUBLE PRINTING?
Printer friendly version

A couple of years ago, HGTV and similar channels filled their program list with shows about flipping houses. The thrust of those shows was that any amateur could finance a house, suffer a few setbacks while spiffing it up, and then emerge with a hefty profit, vowing to flip again. Buying call options was like that, too, from July 2006 through February 2007. New traders didn't need to know a lot about optimal entries and exits, setting stop losses or profit limits, because prices generally just climbed.

That changed, both for the flippers and the call buyers. The housing market declined so fast that inexperienced flippers were caught, their carrying and renovation costs exceeding the declining value of homes. The more experienced flippers could still make money in some cases, choosing the houses where the most value could be added and getting in and out quickly. However, even some experienced flippers were caught occasionally. They had to know how to keep their losses minimal, sometimes by cutting the asking price of the house low enough that they could sell it before the market declined further.

If you're buying calls and puts, you're flipping in a declining market. That's because options are a wasting asset, with part of their price tied into what is commonly called the "time value" of the option. The time value, more properly called "theta," is a major reason that you pay more for an option that is fifty days from expiration than you would the same strike option only five days from option expiration.

For example, with the SPX at 917.56 on October 22, the November 915 call was 29 days from expiration. That call had a bid/ask of 60.00 x 67.90. The December 915 call was 57 days from expiration. Its bid/ask was 70.10 x 80.10. Although other factors, including volatilities, impact the price difference, the major difference was the time value still left in the December version versus the November one.

That time value is like the value of houses in a declining housing market. The more time a house flipper spent renovating the house, the more potential value the house lost in that declining market. Similarly, the longer you hold onto an option, the more the part of its price that depends on time value or theta decays.

A second article will discuss theta in more detail, but here's a basic fact: when you buy a call or put to open an options position, that call or put has a negative value for theta. That means, for every day that goes by, theta subtracts from the value of the option. That's why the minus sign is there. Most online brokers have quoting systems that allow you to determine the theta value of any option you're considering. If you don't know how to find out that information, check with support on your trading platform.

If, when you open an options position, you were to sell that call or put, perhaps as part of a combination options strategy such as a spread or a calendar, the option you sold would experience time decay, too. This time, it would be the person or institution who bought it from you losing money in that option due to the time decay. That's why some options traders consider diversifying their options trades so that they're not just buying calls or puts. They learn about options strategies that benefit from time decay rather than suffer from it. Some of those include credit spreads or calendars.

In a recent CBOE-sponsored seminar, "Real Trading with Dan Sheridan," Sheridan's presentation materials included an example of a LMT calendar in which he had sold 10 April 30 calls and bought 10 June 30 ones. The position had a theta of +15.3. This meant that the 10 contracts in the calendar, originally opened for $2,730, gained $15.30 each day that passed due to the theta effect. Of course, prices and volatility changes could also impact how the calendar performed and could undo the benefits of theta-related decay.

This combination trade Sheridan detailed would be a positive-theta position, which means that the person who established this calendar benefited from time decay rather than suffered from it. The idea is that, barring a strong price movement or change in volatility, the time decay would shrink the value of the April call that was sold faster than it would the value of the June one that was bought. Theta-related decay accelerates quickly as option-expiration approaches, so the two options would not experience the same theta-related decay rate. If the April call's value shrunk quickly enough while the June one's value stayed more stable, the trader could close the position for more money than was paid for it, pocketing the difference.

Of course, many other factors such as the price movement and any changes in volatility will impact whether that trade would be profitable. This article is not a recommendation to jump into a combination trade that you don't fully understand. That trade Sheridan detailed in his presentation materials was included in his materials because it eventually required some adjustments when volatilities dropped so fast that they undid the benefits of the theta-related decay. He wanted to show what could be done to repair a calendar-gone-wrong, something that should be understood before any new type of trade is attempted.

Instead of recommending that new traders jump into combination trades that they don't yet understand, this article should be viewed as an invitation to consider diversification in your options trades. In fact, it's more than an invitation: it's an urgent request to learn as much about diversification as you can. On our site and others, you'll learn about all kinds of options trades but always diversify in a measured way. Learn, experiment with a new strategy on a virtual trading platform, trade it in small numbers and don't escalate until you've gone through a bad month and have successfully weathered it without losing too much.

There's a time and a place for trading long calls and puts. A strong trending market provides price movement that's often large enough to offset the theta-related premium decay, for example. However, options traders should always remain aware that what they're doing is a bit like flipping houses in a declining housing market. Markets experiencing sideways consolidation allow options premium to leak out. Prices chopping sideways up or sideways down may produce price moves in the direction of an option trader's trade, but not quickly enough to overcome theta-related premium decay.

Future articles will pinpoint more information about that theta-related premium decay so you can avoid being a flipper with a wasting asset on your hands.

Options 101 Archives