A Lesson On Time Decay And How To Go In the Money For Top Buys

The Smart Profits Report: Issue #307
Tuesday, May 9, 2006

A Lesson On Time Decay And How To Go In the Money For Top Buys
By Lee Lowell
Advisory Panelist, Mt. Vernon Research

As an options trader, you’re probably aware of many of the pitfalls out there.

Some apply only in certain situations; others apply all the time. Included in the latter is “time decay.” It’s an obstacle that causes options to lose a little bit of their value day after day, regardless of whether the stock or commodity moves much.

Let’s go over this in a bit more detail.

Anatomy Of An Option Price

There are six determinants to an option’s price:

Current price of the underlying security
Strike price of the option
Volatility
Days to option expiration
Interest Rates
Dividends (stock options only)

The option’s price can then be broken down into two parts: Intrinsic Value and Extrinsic Value.

Intrinsic value: This describes the relationship between the stock or commodity’s current price and the strike price of the option, and encompassesthe first and second items from the list above.

These relationships are described in familiar terms: Out-of-the-money (OTM), at-the-money (ATM) and in-the-money (ITM).

ITM options are the only ones that have true value, or intrinsic value. An example of an ITM option would be buying the $30 call on a $50 stock. The $30 call has $20 of real value - or intrinsic value - built into the option price. That option may cost roughly $20.30, where $20 is associated with intrinsic value.

On the other hand, if you bought the $60 call on that $50 stock, you’d be buying an OTM option which has no real value, or intrinsic value, hence its price would entirely be made up of extrinsic value.

Extrinsic value: This describes the part of the option that encompasses the first through the fourth items in the list above.

In the ITM option price above of $20.30, the $0.30 is associated with extrinsic value. Time decay falls under the extrinsic portion of the option’s price, and that’s what we’ll discuss here.

What Time Decay & Extrinsic Value Mean To You

When you purchase an OTM option, you are essentially buying a security that has no real value to it yet. You’re buying something on “hope.”

For example, if IBM is $80 a share and you’re bullish, you may opt to buy the $90 call. What you’re doing is paying a little bit of money today in the form of the option premium in exchange for the hope that IBM will go above $90 a share before expiration.

Since that option has no real value to it yet (no intrinsic value), the option premium is made up entirely of extrinsic value. A hypothetical price for that $90 call may be $2.65, where all of that premium is extrinsic value, or “hope” value.

So let’s say our option price starts at $2.65, and we have two months before expiration with IBM at $80 a share. IBM then starts trading in a price range between $80 and $85, with a dip down to $78 and a rise up to $87.

So is that option worth anything yet? Well, yes and no. It still has a price, but it’s still OTM with no real value to it.

Another Month Goes By…

IBM is at $82 a share. IBM hasn’t really gone anywhere and there’s less chance now that it will get past $90 a share. So our option is losing value and might be worth $1.65 now. We’ve lost $1 in option value just because of the passage of time.

Even if IBM rises to $89 a share by expiration, our option will still expire worthless because IBM didn’t get above $90. Actually, you’d need IBM to go above $92.65, as that is what our cost basis would be ($90 strike price plus $2.35 option price = $92.35 cost basis).

Is There A Way to Get Around Time Decay?

Absolutely. My advice is to always buy ITM options. These are options that have intrinsic value already built in. ITM options are the ones with the lowest amount of daily time decay, so they will suffer the smallest loss due to the passage of time. ITM options have the highest proportion of intrinsic to extrinsic value.

ITM will always cost more in total dollars, but you’ll still be paying less for it than you would if you bought the stock outright. Our hypothetical $30 call option cost us $20.30, meaning $2,030 in actual cash outlay, but if you bought 100 shares of stock, it would cost you $3,000.

If you’re still intent on buying OTM options, which everyone does now and again, my advice would be to buy even more time. That would entail going out to a longer-dated option.

Yes, the option will cost more in total dollars, and yes, you’re still paying for time, but you’re giving yourself more of a chance to be right.

Good Trading,

Lee Lowell

Today’s Smart Profits Cribsheet

I’m not the only who favors in-the-money options… Just this afternoon, subscribers to the Xcelerated Profits Report locked in a 31.9% gain in just over two weeks going “deep” in the money on a communications growth stock. When Mt. Vernon Research Advisory Panelist Jim Stanton first recommended the option play last month, he pointed out the company’s improving fundamentals, strong management team and the technical indicators that were screaming, “Buy now!” And it paid off… Learn more here about the Xcelerated Profits Report, and find out how to get involved in the next recommendation.
You know that I’m a fan of buying in-the-money options because they have real, or intrinsic, value… But there are ways to profit with of out-of-the-money options, too. I’ve put together a simple electronic guide to making money from investors buying these options. How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks is a handbook that can get you started pulling in extra income right away, and it’s e-mailed directly to your inbox… Learn more about this special report here.
Also, follow Steve McDonald’s essential guide for options traders and how to avoid the most common mistakes in Smart Profits #273, Common Option Mistakes: Four Options Resolutions to Make Today.
Don’t forget to check out the Smart Profits Glossary for definitions of terms like “intrinsic value” or “time decay” found in today’s article.