Options are by their nature time sensitive financial instruments, which diminish in value over time and have an expiration date, after which they are worth zero, so time is a very important aspect of profitability, “the ability to make a profit, or earn money” in options trading.
Now people who come to options trading as newcomers are often attracted by the low barriers to entry and high leverage. In other words you don’t need large amounts of money in a relative sense to trade options and option trading by its nature allows you to buy or sell contracts, which provide control over 100 shares of sometimes very expensive stock at a fraction of the cost of buying. However options expire, so time is a huge factor.
In options trading time is your friend when you sell and your enemy when you buy, because options have expiration dates and all option trades are prefaced on something called a market assumption. A market assumption, simply explained is your assumption or belief about the direction of the market during the time of the trade. In options trading your assumption only matters during the life of the option and that is key.
For example, You can be longterm bullish on Apple, but know that in the near term they are likely to miss their earnings estimate, as in their earnings will be less then anticipates, so in the options trading world you would expect the stock to be flat or slightly down, so your market assumption for a trade would be bearish and you would place trades expected to benefit from short term bearishness.
The problem with market assumptions is that they are often right, but the time frame was wrong. I may have a bullish assumption and place my trade accordingly, but the market might remain bearish until my options expire, and then turn bullish. I will potentially lose money on that trade that I wouldn’t have lost if my option expiration date was further out.
For example, I buy calls on Apple because I am bullish, my expiration date is 1-2 days after earnings. The news leading up to earnings is that Apple with a recent record breaking one trillion dollar marketcap will most likely experience a sell off leading up to earnings release day. Why? Because many investors know that if Apple misses its earning projections stock investors, who are fair weather friends will sell. In fact as news leaks of the impending earns call being bad news the price will slowly drop. Your calls you bought will lose value rapidly and you will sell at a loss or experience a total loss because they become worthless. But when weak hands sell, string hands on the sidelines buy, so within a week or two Apple stock price will probably rebound above the price it was when it first started dropping due to the bad news about the earnings report. And if your options expiration date was two weeks after after earnings your bullish assumption would be proven to be right. Then you would make money by selling your options at a profit.
The problem is not that your bullish assumption on a company announcing 4.3 billion dollars in profits for the quarter was wrong, it’s that you didn’t give yourself enough time to be right.
Remember, options are time sensitive financial instruments, and the majority have no intrinsic value, only time value, as in how much time you control contracts of one hundred shares. You could be right about the overall direction of the market, but as the price action has many peaks and valleys, your options will expire worthless if they expire close to a valley, but you will be able to sell them for a profit if their expiration is after a peak, so they are valuable.
Example,
You buy the 210 calls on Apple when it’s trading at 200. These cost 1.00 a piece or 100 per contract. The 100 is all time value and when your time runs out, the options are worthless. If the price of Apple rises to 212 a week before your options expire, those options may now be worth 2.00 an increase in their intrinsic value, which means your strike price 210 is below the market price of 212. You can sell those for a profit close to 100%.
However if Apple remained below 210 until 2 days after your options expired, those same options would have no intrinsic value as your 210 strike price was above the market and as your expiration date approached your time would be almost zero and the “extrinsic” or “time value” of your options would be almost zero. They would expire worthless and you would lose your investment. The sad thing is that if Apple rose to “212” 2 days later you would be heartbroken because you could have made money then.
The take home lesson is to give yourself enough time to be right when your buying options. You will be tempted to buy the shorter duration options because they are cheaper and allow you to control more shares and potentially have more profits. But you gain nothing if you run out of time. Give the market assumption you have time to develop. In options it’s not enough to be right, you have to be right at the right time.
Stay thirsty for knowledge my friends!
✍️ written by Shortsegments
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