The Ugly Truth About Buying Options

by Joshua Belanger

Now, if youve read Why You Should Avoid Trading Options All
Together, youll know that Im a huge fan of selling option premium
(responsibly). In fact, Im constantly surveying the market for
unusual options activity looking for the best trading candidates
(using my SIZZLE Method).
Often times, premiums get jacked up after these monster-sized
institutional orders hit the tape thats when Ill look to be a seller
of high premium (or possibly construct a spread, to slow down the
role of time decay and reduce the effect of implied volatility).
I just feel that risk vs. reward it makes the most sense.
However, that doesnt mean you should never buy options, in fact,
being a premium buyer has its own unique benefits. Namely, the
opportunity to have greater returns if something extraordinary
happens to the stock price of a company.
Of course, it can be very tricky, that is, selecting the right option
strike price and expiration period. Hence, most option buyers end
up failing falling flat on their face and end up losing money on
their trades.
Are you losing money because youre buying too much time or
not enough?
Are you seeing the stock price move in the direction you
predicted, but still end up losing on the trade?
Look, there is a learning curve involved with trading options, and if
you answered yes to any of these questions, its OK. No one was
born with the knowledge to trade options; they all learned from
studying and trading the markets.
For many, that means learning from mistakes (AKA paying your
tuition to the market in the form of trading losses).
Besides, I wouldnt be honest if I told you that I havent paid my fair
share of tuition in the past. However, Id like to think Ive
graduatedand Im ready to share with you a couple of things Ive
learned about buying options outright.
1. When you buy options, you are not just trading direction. Many
new investors think that if they buy a call and the stock price goes
up, theyll make moneyor if they buy a put, and the stock price
drops, theyll make money. WRONG!
2. There are several components that go into pricing an option. Most
importantly, the price movements of the stock, the option strike
price selected, the time to expiration and the implied volatility. The
option pricing model is simply a probability model.
3. An option is composed of intrinsic value and extrinsic value.
Example:
FACEBOOK on April 1, 2014 closed at 62.62

The mid-price for the 4/ 4/14 (expiration) 61 call is $2.01
Intrinsic value is what the option would be worth if today was
hypothetically expiration.
In this case, the intrinsic value is $1.62.
The extrinsic value is the time value and volatility component.
In this case, its $2.01 minus $1.62 or $0.39.
The mid-price for the 4/4/14 (expiration) $62.5 call is $1.04

The intrinsic value $0.12 and the extrinsic value is $0.92. As you can
see, time value and volatility consist of most of the value in this
option.
Remember, at expiration, all options are left with their intrinsic value.
Its just another way of saying that they will either expire in the
money or expire worthless.
In this case, if the stock settled at $62.62, these options would lose
88% of their current value. With only three days to expiration, you
can see how quickly the time value and volatility get sucked out of
these options.
4. Only in-the-money options have intrinsic value. With that said, at-
the-money and out-of-the-money options have extrinsic value only.
The deeper in-the-money an option is, the more the option price will
move along with the underlying stock.
An at-the-money option will move with the stock, however, it has to
overcome the time value (that is accelerating)the option may gain
value if option volatility risesor the option may lose value if option
volatility drops.
5. Near term option trading is referred to as trading gamma and
farther out (in time) option trading is referred to as trading vega.
What does that mean? It means if you select near term options to
buy, you are making more of a bet on the directional move of the
stock.
If you select farther out options, you are not only making a bet on
the direction of the stock, but you are also betting that the option
volatility rises. (The option Greek Vega measures the sensitivity to
volatility).
Now, there is nothing wrong with trading longer term options that
only have extrinsic value, however, most directional traders arent
really sophisticated enough to have an opinion on whether or not
option volatility is cheap or expensive.
In fact, this is where a lot of the mistakes occur. If you are buying at-
the-money or out-of-the-money options, you need the directional
move to overcome the time decay and you need option volatility to
rise.
Whenever you buy an option outright, youre always long vega (or
option volatility).
A perfect example would be after an earnings announcementin
almost all cases, option volatility gets crushed, sometimes so
muchthat it overcomes the gain made from the stock moving in
your direction, which ends up causing the option to be a loser.
6. Time value always accelerates as we approach expiration.
Further, option volatility is a wild card. In fact, it can be driven by a
number of different factors.
For example:
Uncertainty- Often times option volatility will be elevated in
biopharmaceutical companies if they have a pending drug approval
announcement. The market doesnt know if the news will be
positive or negativehowever, they feel that it will cause the stock
price to have a monster-sized move.
A recent case is Mannkind (MNKD). On April 1, 2014, the stock was
trading at around $4 per share. The $4 calls and puts (straddle),
expiring on 4/4/14 were pricing a +/- $2.40 move.
After the close, their diabetes drug got FDA approval and the stock
price gained over 100% in the after-hours.
The following trading day, option volatility got crushed because the
uncertainty disappeared.
Supply & Demand- This usually occurs from unusual options
activity. For example, on April 1, 2014, Gastar Exploration Inc (GST)
saw 7.5x usual options volume.
This demand for options caused the implied volatility in the options
to have a huge spike.
In fact, the implied volatility had a change of over 21.2%.
On the flip side, if large option sellers come into the market, the
value of the option premium decreases and implied volatility
declines.
7. The higher the implied volatility is, the more expensive an option
is. The lower the implied volatility is, the cheaper an option is.
8. Delta is the Option Greek that tells us how much we expect the
option to move in relation to the stock price movement. For
example, if we are long a 50 delta call option, and the stock moves
up $1, we can expect to make $0.50 on our option. Keep in mind, we
will lose some money from the time decay.
Also, we will make money if implied volatility rises or we will lose
money if implied volatility declines.
Ultimately, if you are going to be using options to make directional
bets, you want to be trading deltas. Ideally, youd like the time value
and volatility component to be reduced as much as possible.
To get a better understanding, check out these options in
FACEBOOK (FB).
FACEBOOK: stock price on April 1, 2014, $62.62
Expiration in 3 days
75 Delta Options
Intrinsic Value: $1.62 Extrinsic Value: $0.39


53 Delta Options
Intrinsic Value: $0.12 Extrinsic Value: $0.92


23 Delta Options
Intrinsic Value: $0 Extrinsic Value: $0.31

Expiration in 31 days
72 Delta Options
Intrinsic Value: $5.12 Extrinsic Value: $1.98

50 Delta Options
Intrinsic Value: $0 Extrinsic Value: $3.93

25 Delta Options
Intrinsic Value: $0 Extrinsic Value: $1.41

Expiration in 81 days
75 Delta Options
Intrinsic Value: $7.26 Extrinsic Value: $2.82

48 Delta Options
Intrinsic Value: $0 Extrinsic Value: $4.58

23 Delta Options
Intrinsic Value: $0 Extrinsic Value: $1.68

As you can see, the greater the delta, the more intrinsic value the
option has. In addition, the closer to expiration, the less extrinsic
value for higher delta options.
Again, if youre buying options for a directional move, you want to try
to reduce the time and volatility component that goes into its pricing.
9. When implied volatility rises, its like adding more time on the
option. For example, when implied volatility rises, the options are
worth morein a sense, its like time was added to the option.
On the flip side, when implied volatility drops, its like time was
taken out of the option. When implied volatility drops, the option
becomes worth less.
Putting it all together
Now, one of the issues that premium buyers have is that they dont
gauge the timing and implied volatility of the option correctly. After
all, their thought process is, if I buy a call and the stock rises, my
options should increase in value.
As weve learned, if you buy an at-the-money option (or an out-of-
the money option), the move in the stock price needs to overcome
what youll lose from the time decay and potentially a drop in
implied volatility.
If your goal is for a directional play only, you want to try limit the
time and volatility aspect. Forgive me if Im sounding like a broken
recordbut I cant stress this point enough.
How do we do this? Well, there are two ways.
First, buy options with high intrinsic value. For example, buy an
option with a delta of 70-75. In many ways this could be viewed as a
stock substitute. However, youve still got a great deal of leverage
and a built in stop.
Often times, equity traders will set stops for themselves, when you
buy an option, youve already defined your risk.
The benefit of this approach is that there isnt much extrinsic value
in the option. With that said, if the stock doesnt move much, you
wont get killed in time decay.
What time frame should you buy?
Well, that should be based on your opinion on where you think the
stock will go.
Is it a day trade, a swing trade or a longer term position?
By answering this question, youll have a better clue on which
option contract to select. For example, weekly options are best for
day trades, for swing trades you can use options that expire in 14-30
days. Of course, for longer term swing trades you can go out 45 days
to 90 days.
Why not longer?
Well, because these options dont have a great deal of extrinsic
value, you can always roll the position, meaning close out one
contract and buy a later dated month. Now, dont get caught up in
these numbers, its really based on where you think the stock will go
and by when.
I know traders who will go out 45-65 days on swing trades and 180
days for longer term trades.

There are no hard rules or magic time framesits really based
on your opinion.
Now, Im not saying you cant make money by buying at-the-money
or out-of-the money optionsbecause you most certainly can.
However, youll need a fast and aggressive move in the stock if
youre trading options with 30 days or less left till expiration.
If you dont see that, the time decay will melt that option premium
away.
When you go farther out in time, you are also betting on volatility to
rise. Again, for the average retail trader, volatility is very
complicated subject matter. It involves doing analysis on historical
volatility and comparing it to implied volatility.
In addition, you have to put it into context to figure out if volatility
is cheap or expensive.
If youre buying an option because you think the stock price
will go up or down, dont you want to make things as simple as
possible for yourself?
I know I do.
Too many times traders get hung up with buying cheap options
because theyre cheap and they can buy a lot of them. They feel that
they are getting a better deal than buying the more expensive in-the-
money options.
Now, the reason why I showed you all those different FACEBOOK
options is that I wanted to show you that expensive options are
actually cheaper than at-the-money and out-of-the money options.
The chances of making money on an out-of-the money option are
not favorable. In fact, the odds are actually horrible.
Besides, your goal is to make money on the trade, not to load up on
as many option contracts as you can.
Second, you can buy a spread. A long spread is simply a long call (or
put) against a short call (or put). Because the option you bought is
more expensive than the one you sold, the trade is done for a debit.
Why would we do this?
Well, by selling an option against our long, we are reducing the
effect of time decay and volatility.
In essence, its another way to play for a directional move. Not only
that, but spreads also reduce your overall cost.
Example:
FACEBOOK (FB) options expiring in 31 days, stock price on April
1, 2014 is $62.62
72 Delta calls: $57.50 strike, priced at $7.10 (with an intrinsic value
of $5.12 and extrinsic value $1.98)
25 Delta calls, $71 strike, priced at $1.41 (with $0 intrinsic value and
$1.41 of extrinsic value)
If you bought this spread, it would cost $5.69. In addition, the
intrinsic value would still be $5.12however, youre extrinsic value
would decrease to $0.57. That means if the stock stayed at the same
price on expiration, youd only lose $0.57.
Not only that, but your break-even point has improved, when
compared to buying the outright call. You see, by selling the $71 call,
weve reduced our exposure to time decay and implied volatility.
Of course, if the stock trades north of $71 at expiration, this spread
could yield a return of over 135%not too shabby.
At the end of the day, youve got to be right on your opinion on
whether or not the stock will trade higher or lower. What Ive done
is shown you two methods to express that opinionthat reduce the
role of time decay and effect of option volatility.
Lastly, Id like to thank you for this post. You see, I get a lot of
questions about this in emails, on Twitter, Facebook and StockTwits.
Id be lying if I said you didnt inspire me to write this.
He who asks a question is a fool for five minutes; he who does not ask
a question remains a fool forever.
I really love that Chinese proverb; I think its so true. With that said,
dont be shy and keep the questions coming. As always, Id love to
hear your thoughts in the comments section below.


If you enjoyed what you read and you want to continue learning more on how to to become successful in financial markets using options, visit
http://www.OptionSIZZLE.com

You can also download your FREE report that teaches you The #1 Secret On How You Can Find Tomorrow's Best Trades Today!

Joshua Belanger is the founder of OptionSIZZLE.com and his dream is to not only create wealth, freedom & options for himself, but for you as well.


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