Gauging Option Valuation

Last month

Last month I wrote about the perils of stop orders and revealed how they can be detrimental for option traders.  One of the major points from that article was the reality of option valuation.  As I pointed out, it is activity in the stock market that determines how options are priced.  For this very reason stop orders are an arbitrary and therefore invalid means to determine when an option position is a losing position (i.e. should be exited).  This does not mean option traders should be willing to accept a 100% loss on an option position; it simply means that there is a better method for making this determination.  To do that, traders must look to the underlying stock in order to better gauge their option position.

Understand the instrument

Options are derivatives which is a unique class of financial instrument whose price is derived from underlying components.  For options, the underlying components are twofold:  First, the time remaining before the option expires and second, the market value of the underlying stock or ETF in relation to the option’s strike price.  These two components, called the time value and intrinsic value (respectively), determine the value of an option.

Intrinsic value

Intrinsic value is the least conceptually complicated component of option valuation.  An option gains and loses intrinsic value based on the movement of the underlying stock or ETF relative to the option’s strike price.  For call options, intrinsic value is gained as the underlying asset appreciates in price.  Once the underlying asset has a market value higher than the call option strike price, the position has gained intrinsic value.  For example, an option position in SPY calls with a $120.00 strike price will have $1.00 in intrinsic value if SPY trades up to $121.00 per share.  For put options, the position gains intrinsic value as the market value of the underlying asset falls.  In either case, option positions with intrinsic value are said to be in the money and those without intrinsic value are said to be out of the money.

Time value

Time value is the second component of option valuation.  An option’s time value is a function of the time remaining until the option expires.  Calculating time value is very simple:  Out of the money options (i.e. those with zero intrinsic value) only have time value, so the time value remaining is the price of the option.  To calculate the time value of an option that is in the money, simply subtract the intrinsic value from the cost of the option.  Continuing with our previous example of SPY calls, we know that the option position is $1.00 in the money.  If the options are priced at $2.40 per option, this means that they have $1.40 of time value remaining.

The time value of an option constantly erodes beginning the moment the option is issued.  This erosion occurs linearly, such that it reduces the time value to zero by the end of the trading day that the option expires.  Let’s assume that the SPY calls we mentioned earlier have 5 trading days left until expiration.  If we divide the time value by the number of days remaining, we can determine the rate of erosion.  In this example, the SPY calls lose $0.28 in time value per day which is equivalent to a 11.7% loss in total value each day (based on the current price of the option $2.40).  This constant devaluation creates the basic goal for options trading:  Option traders are simply trying to purchase options which gain intrinsic value at a rate faster than they lose their time value.

Putting it all together

Since the time value erodes linearly, determining the potential change for the intrinsic value is paramount for gauging the potential success or failure of an option position.  By developing a history with a particular stock or ETF, option traders can make better decisions about when to exit a trade based on the movement of the underlying asset and not the movement of the option position.  The most practical way to do this is to identify the potential movement in a day’s worth of trading for the underlying asset.  For example, on a typical trading day the Powershares ETF QQQQ will move no more than 1% to 1.5% in one direction.  Keeping this range in mind, it is easy to estimate an exit price based on the market value of QQQQ that signals when to sell an option position at a loss.

This exit price, which I will refer to as the point of no return, is based on the typical daily movement of the underlying asset and the number of days in which an option trader has remaining to make a return.  Finding this price is best explained via an example:  If an option trader purchases QQQQ weekly call options on Friday and is looking to profit in the following week, he/she has 5 trading days to build intrinsic value on the option.  A conservative point of no return is therefore in the -2.5% to -3% range of the market value of QQQQ at the time the trader opened the option position.  If QQQQ falls to this price point by Wednesday of the following week, it is extremely unlikely that the option position will recover from the loss since the ETF only has two trading days to recover.  If instead, the same option trader is looking to profit in the next trading day (Monday), the price point should be adjusted accordingly (for example -1%).

Developing a point of no return protects option traders from an all too common phenomenon:  Getting stopped out only to see the option position bounce back.  By knowing the typical activity for a stock or ETF, traders can establish realistic expectations for market activity and establish loss points that are truly relevant.

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