Trading options and making profits is exhilarating — everybody likes to talk about their winning trades. Those aren’t like making the winning touchdown at the Super Bowl, in which the most-disciplined and, let’s face it, the luckiest player on the team gets the honor and will probably never have such an honor again for the rest of his career. No, with options, you can make winning play after winning play — you’re the one who can move the odds into your favor, time and again.
Traders are often caught off guard by how quickly options can lose their value thanks to decreasing stock value, as a small move in the underlying shares can translate into an option position that gets wiped out within minutes.
Time decay — a risk that comes with every option position you establish — serves to create the second half of a one-two punch that can turn otherwise-solid positions into Swiss cheese.
Time decay is exactly what it sounds like — the closer an option is to the end of its life cycle, the more quickly it loses its value. Also, the longer a trade stays in the red, the less likely it is to rally back up to breakeven or even into profitability before options expiration rolls around.
Of course, we don’t trade options to lose — we trade them to win … and win big. Trading options as a speculative bet that a stock will go up (or down) gives us an incredible opportunity to double or triple our money. But whether we win or lose is dependent upon how the stock is trading.
WHAT CAN HAPPEN TO A LONG OPTION POSITION?
When you buy an option, the underlying stock can do one of three things.
1. It can go in the direction you believe it is going to go. (A long call option becomes profitable when the stock trades up to, and through, the strike price; a long put option becomes profitable when the stock drops down through the strike price.) When the stock crosses the strike price in your favor, that makes the trade in-the-money. The deeper the in-the-money the option, the higher your potential returns.
2. It can trade in the opposite direction. If this happens, you may lose the full value of your investment if the stock doesn’t change direction during the life of your trade.
3. The stock enters a holding pattern. If the stock trades relatively flat, your option could expire worthless, thanks to decreasing value due to time loss. (This is for options that are trading out-of-the-money; if the option is in-the-money, there is value by closing the option position or by exercising it.)
In some instances, the option may lose value even if the underlying stock is going in the direction you hoped it would. This is because the value of the time loss exceeds any increase in the value of the option due to changing stock prices.
This is where stocks and options diverge significantly. Where stocks will still hold some value in neutral and declining markets — barring any dramatic events specific to the individual company — options can lose much or all of their value.
WHAT HAPPENS WHEN IT’S TIME TO HIT THE EXITS?
So, let’s say you’ve bought an option and are wondering what to do with it, and when. What you can do depends whether the trade is working in your favor.
When you buy an option, the purchase price is non-refundable and you can only make a return on your option by closing the option trade before its expiration date or exercising the option (i.e., buying stock at the strike price if it’s a call, or selling stock at the strike price if it’s a put).
Failure to act before expiration date means that an in-the-money option is exercised for you (unless you instruct your broker beforehand to directly close the position) and an out-of-the-money option expires worthless and you lose everything you invested.
Some have lost money even when their option was profitable because they failed to act before the expiration date or didn’t take advantage of the opportunity to exercise their option. Some stockbrokers will now automatically exercise your option on your behalf and purchase the underlying stock (again, unless you tell them otherwise), provided there is a profit in it for you.
This differs from the stock, though you may fail to sell a stock at its most profitable moment, it can still have some inherent value. Out-of-the-money options lose their value at expiration date.
Even if your stock is moving in the wrong direction, it is possible to recoup some of your losses by closing your option trade prior to its expiration date. However, just as options allow you to make an investment for just pennies on the dollar, closing a trade that didn’t work out in your favor also reflects a payout of only pennies on the dollar as well.
Either way, whether you win big or not at all, trading options can be an inexpensive activity that ensures that you don’t lose big!
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