Option trading with DanPickUp
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Hi
One more post about delta and if you have more questions about the option Greeks, please use the link I provided in post 29 and search there for more information or organize a book about the option Greeks. It is absolute basic stuff. If you still have any problems, PM so we can move on with the thread.
The target of this thread is still to finally have an idea about options and to have a simple trading plan you can use in the future before you enter an option trade. I am clear, that the last subject: How to implement a strategy, is on a level most of Indian option traders never tried and never will experience. Even then, it expands your mind what can be done in option trading as many post in this forum expanded my mind what can be done in future trading. You call it may Karma and I call it take and give.
Now to the delta question as asked: How to calculate delta?
Delta is the measure of the change of an options value with respect to a 1 point move in its underlying (stock, future, commodity, etc.). Calls have a positive delta while puts have a negative delta.
Quantifying the Delta of a Call or Put
Complex mathematical equations are used to derive an option' s delta. Delta can also be thought of in terms of probability. An option' s delta is the probability that it will be ITM (in-the-money) at expiration. An option that has a 30 delta (written as .30 deltas) has a 30% chance of being ITM (having intrinsic value) at expiration. A person who buys that option on 100 separate occasions, statistically could expect to see it expire with intrinsic value about 30 times out of 100.
How Are Deltas Calculated?
Deltas (as well as all of the Greeks) are derived from the area under a probability curve. Simply stated, the normal distribution curve (Bell curve) measures the likelihood of any particular event occurring. With an ATM call (or put) the likelihood that the option will be ITM or OTM on expiration is roughly 50/50 . Random walk theory says that the stock could either go up or down. As the option is exactly ATM when the stock is set free to move as it will, there is no advantage or e dge as to whether it will be ITM or OTM. The graphs on the next page help illustrate the relationship between stock price and strike price when measuring the probability of an option being ITM or OTM at expiration.
How Does Delta Work?
Delta measures how much we could expect an option to move after a Ipoint move in the underlying. If a stock had a delta of . 50 (phrased verbally as "50 delta"), we know that that option will move $ 0.50 cents for every dollar the underlying moves . If the option has positive deltas (long calls or short puts), it will result in a profit as the stock advances. Should the option have a negative delta (long puts or short calls), a profit should result as the stock declines. How much of a profit? The delta ' s equivalent of a profit, so if an index or stock moves 1 point (and the option is a 50 delta option), the option will move $0.50.
Call Example with Stock Increasing
Stock RSR is trading for $95 per share. If we bought the 95-strike call in the anticipation that the stock was going to make a $ 1 move (to $96 per share), what would the option that we paid $4 for be trading at after the move? Delta answers the question.
Given that the delta of the $95-strike call is .50 (all ATM options are 50 deltas - long calls are positive and long puts are negative deltas), the option will move $0.50 cents for the first dollar the stock moves. The 95-strike call starts out trading at $4 and would end (with the stock at $96) trading at $4.50.
Example :
[stock move $ 1 x option delta 0.50] + call starting price of $4 =[$0.50] + $4 = $4.50
Call Example with Stock Declining
Delta works exactly the same with the stock declining. Had the stock gone down $ 1 , from $95 to $94, the option that has a positive delta would lose $0.50 and end up trading at $3 12. Because a call option has a positive delta - it increases in value as the stock goes up, and decreases in value as the stock goes down.
Example :
[stock move (-$ 1 ) x long call option delta 0.50] + call starting price of $4 = [-$0.50] + $4 = $ 3.50 = ending call price
Put Example with Stock Increasing
Our trader is still bullish on stock RSR; however, he owns stock and wants to protect it with a put. He opts to purchase the stock at $95 and purchase the 85 - strike put for protection for $ 1.12. The 85 -strike put has a .35 delta. Should the stock increase in value to $96, the trader will make $ 1 on the stock, but what happens to the put?
The put has a negative .35 delta; therefore, it loses value as the stock increases. In this situation, the one point upward move by the underlying results in a $0 .35 loss in the put. The put will be worth $ 1.151 5 ($ 1.50 - $ 0.35 = $ 1.15).
Example :
[stock move ($ 1 ) x long put delta (-0.35 )] + $ 1.50 put starting price = [-($0.35)] + $ 1.50 = $ 1.15 ending put price
Put Example with Stock Declining
Had the stock gone down, the negative delta multiplied by the negative move of the stock would have resulted in a positive increase in the price of the put by $0.35.The ending price of the put would be $ 1.85 ($ 1.50 + $ 0.35 = $ 1.85).
Example :
[stock move (- $ 1 ) x long put delta (-0.35)] + $ 1.50 put starting price = [$0.35] + $ 1.50 = $ 1.85 ending put price.(*)
(*) Source: Option Greeks for profit from J.L.Lord
DanPickUp
One more post about delta and if you have more questions about the option Greeks, please use the link I provided in post 29 and search there for more information or organize a book about the option Greeks. It is absolute basic stuff. If you still have any problems, PM so we can move on with the thread.
The target of this thread is still to finally have an idea about options and to have a simple trading plan you can use in the future before you enter an option trade. I am clear, that the last subject: How to implement a strategy, is on a level most of Indian option traders never tried and never will experience. Even then, it expands your mind what can be done in option trading as many post in this forum expanded my mind what can be done in future trading. You call it may Karma and I call it take and give.
Now to the delta question as asked: How to calculate delta?
Delta is the measure of the change of an options value with respect to a 1 point move in its underlying (stock, future, commodity, etc.). Calls have a positive delta while puts have a negative delta.
Quantifying the Delta of a Call or Put
Complex mathematical equations are used to derive an option' s delta. Delta can also be thought of in terms of probability. An option' s delta is the probability that it will be ITM (in-the-money) at expiration. An option that has a 30 delta (written as .30 deltas) has a 30% chance of being ITM (having intrinsic value) at expiration. A person who buys that option on 100 separate occasions, statistically could expect to see it expire with intrinsic value about 30 times out of 100.
How Are Deltas Calculated?
Deltas (as well as all of the Greeks) are derived from the area under a probability curve. Simply stated, the normal distribution curve (Bell curve) measures the likelihood of any particular event occurring. With an ATM call (or put) the likelihood that the option will be ITM or OTM on expiration is roughly 50/50 . Random walk theory says that the stock could either go up or down. As the option is exactly ATM when the stock is set free to move as it will, there is no advantage or e dge as to whether it will be ITM or OTM. The graphs on the next page help illustrate the relationship between stock price and strike price when measuring the probability of an option being ITM or OTM at expiration.
How Does Delta Work?
Delta measures how much we could expect an option to move after a Ipoint move in the underlying. If a stock had a delta of . 50 (phrased verbally as "50 delta"), we know that that option will move $ 0.50 cents for every dollar the underlying moves . If the option has positive deltas (long calls or short puts), it will result in a profit as the stock advances. Should the option have a negative delta (long puts or short calls), a profit should result as the stock declines. How much of a profit? The delta ' s equivalent of a profit, so if an index or stock moves 1 point (and the option is a 50 delta option), the option will move $0.50.
Call Example with Stock Increasing
Stock RSR is trading for $95 per share. If we bought the 95-strike call in the anticipation that the stock was going to make a $ 1 move (to $96 per share), what would the option that we paid $4 for be trading at after the move? Delta answers the question.
Given that the delta of the $95-strike call is .50 (all ATM options are 50 deltas - long calls are positive and long puts are negative deltas), the option will move $0.50 cents for the first dollar the stock moves. The 95-strike call starts out trading at $4 and would end (with the stock at $96) trading at $4.50.
Example :
[stock move $ 1 x option delta 0.50] + call starting price of $4 =[$0.50] + $4 = $4.50
Call Example with Stock Declining
Delta works exactly the same with the stock declining. Had the stock gone down $ 1 , from $95 to $94, the option that has a positive delta would lose $0.50 and end up trading at $3 12. Because a call option has a positive delta - it increases in value as the stock goes up, and decreases in value as the stock goes down.
Example :
[stock move (-$ 1 ) x long call option delta 0.50] + call starting price of $4 = [-$0.50] + $4 = $ 3.50 = ending call price
Put Example with Stock Increasing
Our trader is still bullish on stock RSR; however, he owns stock and wants to protect it with a put. He opts to purchase the stock at $95 and purchase the 85 - strike put for protection for $ 1.12. The 85 -strike put has a .35 delta. Should the stock increase in value to $96, the trader will make $ 1 on the stock, but what happens to the put?
The put has a negative .35 delta; therefore, it loses value as the stock increases. In this situation, the one point upward move by the underlying results in a $0 .35 loss in the put. The put will be worth $ 1.151 5 ($ 1.50 - $ 0.35 = $ 1.15).
Example :
[stock move ($ 1 ) x long put delta (-0.35 )] + $ 1.50 put starting price = [-($0.35)] + $ 1.50 = $ 1.15 ending put price
Put Example with Stock Declining
Had the stock gone down, the negative delta multiplied by the negative move of the stock would have resulted in a positive increase in the price of the put by $0.35.The ending price of the put would be $ 1.85 ($ 1.50 + $ 0.35 = $ 1.85).
Example :
[stock move (- $ 1 ) x long put delta (-0.35)] + $ 1.50 put starting price = [$0.35] + $ 1.50 = $ 1.85 ending put price.(*)
(*) Source: Option Greeks for profit from J.L.Lord
DanPickUp
Hi
Subject number nine: Entering the market.
What ever we do in trading, we should have knowledge about what kind of order possibilities we have to enter or exit a trade in the market. As we now have an idea about the different ways we can implement a whole option strategy in the market, we now have to know a bit more about the order types we can use to enter our trades in the market.
Most common order types are:
Market orders (MKT)
Limit orders (LMT)
Stop loss orders
Stop limit orders
Trailing stop orders
Market on open (MOO)
Market on close (MOC)
Market if touched (MIT)
Good till canceled (GTC)
Good for the day (GFD)
One cancels the other (OCO)
One triggers the other (OTTO)
Fill or Kill (FOK)
All or none
Day order
(*) Some links on the bottom of the post in case you are not familiar with this order types.
Quit a few choices, dont you think so? By the way: There are many more order types. (**) Check with your broker or in your trading platform what kinds of orders are possible. Choosing here the right one for the right case will have a direct impact to the outcome of your trades.
Now, when to use what order type? To not get confused with all that orders, we will concentrate only on a few useful order types for option trading. The first four order types are mostly used from directional option traders. We also can use them if we want to leg in any strategy.
Buy To Open
A Buy To Open order is the most common option order in option trading. It means to "Open a position through buying that option contract", which simply means to buy or go long on a certain option contract.
Sell To Close
A Sell To Close order is the second most common option order in option trading. It means to "Close a position through selling that option contract", which simply means to sell a certain option contract that you own.
Sell To Open
A Sell To Open order is a less commonly used option order in option trading. It means to "Open a position through selling that option contract", which simply means to short sell a particular option contract.
Buy To Close
A Buy To Close order is the order to make to close a Sell To Open position. It means to "Close a position through buying that option contract", which simply means to buy back an option contract which you have previously sold short.
Combination Orders
Many option strategies requires a combination of different option contracts, placed using a combination of the above orders. For example, a Bull Call Spread making up of a Long At The Money Call Option and a short Out Of The Money Call Option. To open this Bull Call Spread Position, one would have to Buy To Open the at the money call options and then Sell To Open the out of the money call options. Conversely, to close this position, one would have to Sell To Close the at the money call options and Buy To Close the out of the money call options.
There are 2 types of combination orders that helps make the job of coordinating the entry or cancellation of multiple option positions easy. They are: One-Trigger-Other (OTO) and One-Cancel-Other (OCO) orders.
One-Trigger-Other (OTO)
Activating a secondary options order when the primary options order fills. This is especially useful for legging into positions such as a Covered Call where you want to sell the call options right after the stocks get filled.
One-Cancel-Other (OCO)
This is a less popular options order which 2 trades are executed at the same time and the filling of one trade cancels the other trade.(***)
Follow up post will be made
DanPickUp
(*)http://www.babypips.com/school/types-of-orders.html
http://www.trading-lessons.com/?cat=7
(**)http://www.interactivebrokers.com/en/p.php?f=orderTypes
(***) Source: http://www.optiontradingpedia.com/types_of_option_orders.htm#order type
Subject number nine: Entering the market.
What ever we do in trading, we should have knowledge about what kind of order possibilities we have to enter or exit a trade in the market. As we now have an idea about the different ways we can implement a whole option strategy in the market, we now have to know a bit more about the order types we can use to enter our trades in the market.
Most common order types are:
Market orders (MKT)
Limit orders (LMT)
Stop loss orders
Stop limit orders
Trailing stop orders
Market on open (MOO)
Market on close (MOC)
Market if touched (MIT)
Good till canceled (GTC)
Good for the day (GFD)
One cancels the other (OCO)
One triggers the other (OTTO)
Fill or Kill (FOK)
All or none
Day order
(*) Some links on the bottom of the post in case you are not familiar with this order types.
Quit a few choices, dont you think so? By the way: There are many more order types. (**) Check with your broker or in your trading platform what kinds of orders are possible. Choosing here the right one for the right case will have a direct impact to the outcome of your trades.
Now, when to use what order type? To not get confused with all that orders, we will concentrate only on a few useful order types for option trading. The first four order types are mostly used from directional option traders. We also can use them if we want to leg in any strategy.
Buy To Open
A Buy To Open order is the most common option order in option trading. It means to "Open a position through buying that option contract", which simply means to buy or go long on a certain option contract.
Sell To Close
A Sell To Close order is the second most common option order in option trading. It means to "Close a position through selling that option contract", which simply means to sell a certain option contract that you own.
Sell To Open
A Sell To Open order is a less commonly used option order in option trading. It means to "Open a position through selling that option contract", which simply means to short sell a particular option contract.
Buy To Close
A Buy To Close order is the order to make to close a Sell To Open position. It means to "Close a position through buying that option contract", which simply means to buy back an option contract which you have previously sold short.
Combination Orders
Many option strategies requires a combination of different option contracts, placed using a combination of the above orders. For example, a Bull Call Spread making up of a Long At The Money Call Option and a short Out Of The Money Call Option. To open this Bull Call Spread Position, one would have to Buy To Open the at the money call options and then Sell To Open the out of the money call options. Conversely, to close this position, one would have to Sell To Close the at the money call options and Buy To Close the out of the money call options.
There are 2 types of combination orders that helps make the job of coordinating the entry or cancellation of multiple option positions easy. They are: One-Trigger-Other (OTO) and One-Cancel-Other (OCO) orders.
One-Trigger-Other (OTO)
Activating a secondary options order when the primary options order fills. This is especially useful for legging into positions such as a Covered Call where you want to sell the call options right after the stocks get filled.
One-Cancel-Other (OCO)
This is a less popular options order which 2 trades are executed at the same time and the filling of one trade cancels the other trade.(***)
Follow up post will be made
DanPickUp
(*)http://www.babypips.com/school/types-of-orders.html
http://www.trading-lessons.com/?cat=7
(**)http://www.interactivebrokers.com/en/p.php?f=orderTypes
(***) Source: http://www.optiontradingpedia.com/types_of_option_orders.htm#order type
There is school of thought which believe not to put Market orders.They
believe Limit orders is always better.When emotions run high sometimes
it is good putting MKT orders.In such scenario ,the market so fast that by
completing the order ,the figure will be changed.Even editing the order many
times is of no use.In such cases placing a limit order ,with 2 notches UP / DOWN
are per market trend will help.Some systems ask you to put market orders as
MKT (instead of price),I think we will give some undesirable results.Put some
price in allocated place,if it is met ; it is executed or otherwise in OPEN orders.
believe Limit orders is always better.When emotions run high sometimes
it is good putting MKT orders.In such scenario ,the market so fast that by
completing the order ,the figure will be changed.Even editing the order many
times is of no use.In such cases placing a limit order ,with 2 notches UP / DOWN
are per market trend will help.Some systems ask you to put market orders as
MKT (instead of price),I think we will give some undesirable results.Put some
price in allocated place,if it is met ; it is executed or otherwise in OPEN orders.
Dan post on delta was just superb :clapping:
So basically those who play plain option intraday trading(Buy call and Buy Put only) then should be using the ITM options with more delta as these will give more movement in relation to the underlying.
But most of us just do the opposite as we go for ATM or OTM as we want to buy more number of lots(less price) but ends up in loss even after predicting good movement on the underlying but the option remains choppy due to less delta.
So basically those who play plain option intraday trading(Buy call and Buy Put only) then should be using the ITM options with more delta as these will give more movement in relation to the underlying.
But most of us just do the opposite as we go for ATM or OTM as we want to buy more number of lots(less price) but ends up in loss even after predicting good movement on the underlying but the option remains choppy due to less delta.
Hi
Timepass, yes you are right with your answers to the first question.
To your second question check this link: http://i44.tinypic.com/153bq81.png . Instead of median I choosed closed and then shifted it horizontal. The effect now is the same as with median MA. Remember: The tool is mainly used as an add visualization to spot trends a bit more easy.
Shiva5109, what you talk about is a long strangle. I did not mention that strategy. Even then: Main request for a long strategy is low vola. Now where to take profit? This screen shot should help:
Now lets move on to the sixth subject which is: Margins for the strategy or any trade.
Definition of option margins:
The cash or securities an investor must deposit in his account as collateral before writing options. This cash is may also be needed to close losing positions.
Why do I mention that little subject? Because of its importance in any kind of trading you do. First rule I was told when I traded the first time in my live: Never ever get a margin call from your broker.
Hmm?
What did that mean? If I have a bad trade and I loose money, the broker will check my account I have with him and he will decide if I have to bring in some more money to trade further. If I not can bring that money, the trade will be closed with the margin money (security money) the broker blocked in my account. If all that money has gone and he needs more money, he will call my house bank or me and ask for some more money. This money he will see now. This then is called: Margin call.
We do not want such calls and we do not get such calls, as we know what margin means and that is why I mention that subject. So, before implementing any trade or strategy we planned, we check the margin which is asked for that trade. This is a MUST and not a maybe. With the time you will know automatically what margins you have with your routine trades.
We can be pure margin traders. That would mean, that we always only have that money with our broker which is needed as margin for this trade we do. As we now had the MFGlobal bankruptcy, which showed the risk we face when putting much money with one broker, I recommend you to place your money with different brokers and never put too much money in to one account. It is all your choice as the meanings about that are various.
Long option trades do not need any margin, as you buy the option and you only can buy what you can pay with the amount which is in your brokers account. If there is not enough money for what you want to buy, it not will be bought. As simple as that.
Shorting options is different. In India the margin for one sold option is always 27000 Rp. As far as I know, it is the same amount like it is for Nify future trading.
If you now buy one option, stock or future and you sell one option in the same strategy, ICICI still want to see the fully 27000 Rp even you are long one other derivative in the same strategy. That means that ICICI not will accept, that you can use an underlying of any kind as collateral. In the USA, this is not of a problem. Example: Neither covered calls nor covered puts have a margin requirement. I hope to the gods of you that the day comes when ICICI changes that rules in India.
Sixth subject closed.
DanPickUp
Timepass, yes you are right with your answers to the first question.
To your second question check this link: http://i44.tinypic.com/153bq81.png . Instead of median I choosed closed and then shifted it horizontal. The effect now is the same as with median MA. Remember: The tool is mainly used as an add visualization to spot trends a bit more easy.
Shiva5109, what you talk about is a long strangle. I did not mention that strategy. Even then: Main request for a long strategy is low vola. Now where to take profit? This screen shot should help:
Now lets move on to the sixth subject which is: Margins for the strategy or any trade.
Definition of option margins:
The cash or securities an investor must deposit in his account as collateral before writing options. This cash is may also be needed to close losing positions.
Why do I mention that little subject? Because of its importance in any kind of trading you do. First rule I was told when I traded the first time in my live: Never ever get a margin call from your broker.
Hmm?
What did that mean? If I have a bad trade and I loose money, the broker will check my account I have with him and he will decide if I have to bring in some more money to trade further. If I not can bring that money, the trade will be closed with the margin money (security money) the broker blocked in my account. If all that money has gone and he needs more money, he will call my house bank or me and ask for some more money. This money he will see now. This then is called: Margin call.We do not want such calls and we do not get such calls, as we know what margin means and that is why I mention that subject. So, before implementing any trade or strategy we planned, we check the margin which is asked for that trade. This is a MUST and not a maybe. With the time you will know automatically what margins you have with your routine trades.
We can be pure margin traders. That would mean, that we always only have that money with our broker which is needed as margin for this trade we do. As we now had the MFGlobal bankruptcy, which showed the risk we face when putting much money with one broker, I recommend you to place your money with different brokers and never put too much money in to one account. It is all your choice as the meanings about that are various.
Long option trades do not need any margin, as you buy the option and you only can buy what you can pay with the amount which is in your brokers account. If there is not enough money for what you want to buy, it not will be bought. As simple as that.
Shorting options is different. In India the margin for one sold option is always 27000 Rp. As far as I know, it is the same amount like it is for Nify future trading.
If you now buy one option, stock or future and you sell one option in the same strategy, ICICI still want to see the fully 27000 Rp even you are long one other derivative in the same strategy. That means that ICICI not will accept, that you can use an underlying of any kind as collateral. In the USA, this is not of a problem. Example: Neither covered calls nor covered puts have a margin requirement. I hope to the gods of you that the day comes when ICICI changes that rules in India.
Sixth subject closed.
DanPickUp
Which software did u use to draw the graph as above to understand the BEP.
Regards
Jovial01
Hi
Jovial01: Next time please ask a question with out posting the whole post again. Imagine you are new to the thread and you read through it. Now you always have to work through this repetition from past post. Isn't it just lost space and confusing?
Thank you.
The software is OpVue6 and it is not free. ( http://www.optionvue.com )
If you look for free software, go for option oracle. There is a lot of information in this forum about this free software. It will do the job for pure option strategies. http://www.samoasky.com/download.html
DanPickUp
Jovial01: Next time please ask a question with out posting the whole post again. Imagine you are new to the thread and you read through it. Now you always have to work through this repetition from past post. Isn't it just lost space and confusing?
Thank you.
The software is OpVue6 and it is not free. ( http://www.optionvue.com )
If you look for free software, go for option oracle. There is a lot of information in this forum about this free software. It will do the job for pure option strategies. http://www.samoasky.com/download.html
DanPickUp
Hi
I got PM and it seems that time decay is not understood. Let me make one more post about it as I am clear about how confusing this can be.
One important dynamic of time value decay is that the rate is not constant. As expiration nears, the rate of time-value decay (theta) increases. This means that the amount of time premium disappearing from the option's price per day gets greater with each passing day.
Time-Value Decay
In the figure below, we simulate time-value decay using three at-the-money S&P 500 call options, all having the same strikes but different contract expiration dates. Through this presentation, we are making the assumption (for simplification) that implied volatility levels remain unchanged and that the underlying is stationary. This helps us to isolate the behavior of time value. The importance of time value and time-value decay should thus become much clearer.
Taking a series of S&P 500 call options, all with an at-the-money strike price of 1100, we can simulate how time value influences an option's price. Assume the date is Feb 8. If we compare the prices of each option at a certain moment in time, each with different expiration dates (Feb, March and April), the phenomenon of time-value decay becomes evident. We can witness how the passage of time changes the value of the options. Figure 1 graphically illustrates the premium for these at-the-money S&P 500 call options with the same strikes. With the underlying stationary, the Feb call option has five days remaining until expiry, the Mar call option has 33 days remaining and the Apr call option has 68 days.
As the figure shows, the highest premium is at the 68-day interval (remember prices are from Feb 8), declining from there as we move to the options that are closer to expiration (33 days and five days). Again, we are simply taking different prices at one point in time for an at-the-option strike (1100), and comparing them. The fewer days remaining translates into less time value. As you can see, the option premium declines from 38.90 to 25.70 when we move from the strike 68 days out to the strike that is only 33 days out.
The next level of the premium, a decline of 14.70 points to 11, reflects just five days remaining before expiration for that particular option. During the last five days of that option, if it remains out of the money (the S&P 500 stock index below 1100 at expiration), the option value will fall to zero, and this will take place in just five days. Each point is worth $250 on an S&P 500 option.
The concept looked at in another way in the above figure; the amount of days required for a $1 (1 point) decline in premium on the option will decrease as expiry nears.
Looking at the exhibit, you can see that at 68 days remaining until expiration, it takes 1.75 days for a one-dollar decline in premium. But at just 33 days remaining until expiration, the time required for a one-dollar loss in premium has fallen to 1.28 days. In the last month of the life of an option, theta increases sharply, and the days required for a one-point decline in premium falls very fast. At five days remaining until expiration, the option is losing one point in just less than half a day (0.45 days). If we look again at the first picture, at five days remaining until expiration, this at-the-money S&P 500 call option has 11 points in premium. This means that the premium will decline by approximately 2.2 points per day. Of course, the rate increases even more in the final day of trading, which is not shown here.
DanPickUp
(*) Source: http://www.investopedia.com/articles/optioninvestor/02/021302.asp
I got PM and it seems that time decay is not understood. Let me make one more post about it as I am clear about how confusing this can be.
One important dynamic of time value decay is that the rate is not constant. As expiration nears, the rate of time-value decay (theta) increases. This means that the amount of time premium disappearing from the option's price per day gets greater with each passing day.
Time-Value Decay
In the figure below, we simulate time-value decay using three at-the-money S&P 500 call options, all having the same strikes but different contract expiration dates. Through this presentation, we are making the assumption (for simplification) that implied volatility levels remain unchanged and that the underlying is stationary. This helps us to isolate the behavior of time value. The importance of time value and time-value decay should thus become much clearer.
Taking a series of S&P 500 call options, all with an at-the-money strike price of 1100, we can simulate how time value influences an option's price. Assume the date is Feb 8. If we compare the prices of each option at a certain moment in time, each with different expiration dates (Feb, March and April), the phenomenon of time-value decay becomes evident. We can witness how the passage of time changes the value of the options. Figure 1 graphically illustrates the premium for these at-the-money S&P 500 call options with the same strikes. With the underlying stationary, the Feb call option has five days remaining until expiry, the Mar call option has 33 days remaining and the Apr call option has 68 days.
As the figure shows, the highest premium is at the 68-day interval (remember prices are from Feb 8), declining from there as we move to the options that are closer to expiration (33 days and five days). Again, we are simply taking different prices at one point in time for an at-the-option strike (1100), and comparing them. The fewer days remaining translates into less time value. As you can see, the option premium declines from 38.90 to 25.70 when we move from the strike 68 days out to the strike that is only 33 days out.
The next level of the premium, a decline of 14.70 points to 11, reflects just five days remaining before expiration for that particular option. During the last five days of that option, if it remains out of the money (the S&P 500 stock index below 1100 at expiration), the option value will fall to zero, and this will take place in just five days. Each point is worth $250 on an S&P 500 option.
The concept looked at in another way in the above figure; the amount of days required for a $1 (1 point) decline in premium on the option will decrease as expiry nears.
Looking at the exhibit, you can see that at 68 days remaining until expiration, it takes 1.75 days for a one-dollar decline in premium. But at just 33 days remaining until expiration, the time required for a one-dollar loss in premium has fallen to 1.28 days. In the last month of the life of an option, theta increases sharply, and the days required for a one-point decline in premium falls very fast. At five days remaining until expiration, the option is losing one point in just less than half a day (0.45 days). If we look again at the first picture, at five days remaining until expiration, this at-the-money S&P 500 call option has 11 points in premium. This means that the premium will decline by approximately 2.2 points per day. Of course, the rate increases even more in the final day of trading, which is not shown here.
DanPickUp
(*) Source: http://www.investopedia.com/articles/optioninvestor/02/021302.asp
Hi
Columbus, I only can double with what you posted. It is always best to do live trades in options to get a feeling how they work.
A friend of mine just informed me, that even option theory in Indias option trading market not really works. He told me, that the option markets are highly immatured and dominated by fast algo orders intraday. He then informed me, that algos are not allowed for retailers.
I am further told, that the delta of the at the money is more than the Nifty movements most of the times and that Options act as leading indicators Intraday in India.
Any way, I will continue with the thread as promised and I will do it the way I started it. The readers here finally may still be able to use some of the stuff which is posted here about my option trading at the CME and the knowledge needed to survive in that huge option market.
By the way: Thanks to the PM sender for this very detailed information about the option trading situation in India.
DanPickUp
Columbus, I only can double with what you posted. It is always best to do live trades in options to get a feeling how they work.
A friend of mine just informed me, that even option theory in Indias option trading market not really works. He told me, that the option markets are highly immatured and dominated by fast algo orders intraday. He then informed me, that algos are not allowed for retailers.
I am further told, that the delta of the at the money is more than the Nifty movements most of the times and that Options act as leading indicators Intraday in India.
Any way, I will continue with the thread as promised and I will do it the way I started it. The readers here finally may still be able to use some of the stuff which is posted here about my option trading at the CME and the knowledge needed to survive in that huge option market.
By the way: Thanks to the PM sender for this very detailed information about the option trading situation in India.
DanPickUp
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