Restaurant Stocks and Amazon

AMZN

The Amazon (AMZN) effect has decimated countless retailers in recent years. As more and more consumers buy online at Amazon and avoid the malls, shares of Macy’s (M), Nordstrom (JWN), J.C. Penney (JCP), L Brands (LB), Foot Locker (FL), and many other retail stocks have been very publicly crushed. But there’s another, less well known mall-related sector that has also been hurt by Amazon: restaurant stocks. I recently saw first-hand why.

A couple of weeks ago, my wife was out of town, and I was in charge of our kids for a couple of days. After soccer practice one evening, I was too tired to cook dinner and decided to take them out to dinner at Five Guys. This was a nice treat for them, as we rarely eat fast food.

However, as I pulled up to the Five Guys, which was in the middle of a very high-end strip mall, I noticed that it was out of business. And so was the high-end coffee shop next door, and the once-successful taco restaurant. I was shocked!

My family is fortunate to live in an affluent neighborhood in a thriving city. Unemployment in my area is low, and you can tell by the cars people are driving and the amount of work crews in the neighborhood that my neighbors are spending money. So why are the restaurants struggling in the nearby mall?

As more and more people shop on Amazon, foot traffic in malls has been collapsing, and the restaurants attached to those malls are feeling the pain.

Mall-Related Restaurant Stocks Hit Hardest

Barclays’ restaurant stock analyst team recently released a research note highlighting the restaurant chains that are most “mall associated” and at risk to weak foot traffic. Here is an excerpt from Barclays’ research highlighting the restaurant stocks at risk:

1st graph

2nd graph

And here are more details from Barclays:

“Cheesecake Factory (CAKE) operates 90%+ of their stores in a location we define as mall dependent. To be fair, CAKE is often viewed as a destination, with its own separate entrance, and therefore less mall-dependent. And most are in ‘A’ malls which house high-end retailers that draw a more affluent consumer. But the consumer shift to online shopping is less about affluence, and more about a change in behavior.”

As you can see in the Cheesecake Factory (CAKE) chart below, the stock has fallen from 66 to 41 in the last several months.

3rd graph

The charts of all the restaurant stocks listed in the Barclays research note look very similar.

How to Profit from the Decline in Restaurants

If I thought that CAKE was headed for even greater stock declines, as an options trader, I would look to buy a put. A put is a bearish option trade, whose risk is limited to the premium paid.

For example, I might buy the CAKE January 40 Puts for $2.15. The most I can lose if I bought this put is $2.15, or $215 (one put equals 100 shares, so a $2.15 put costs $215).

The limited risk is what makes buying a put such a great tool. If I were to sell short 100 shares of CAKE stock, my upside risk would be unlimited. And if CAKE was taken over or if the stock had already priced in the mall traffic worries, the upside on my short stock is infinite.

With a put, my only risk is that $215.

If CAKE continues to fall before my put expires in January, the put would increase in value by $100 for every $1 CAKE drops below 37.85.

(Here’s the math behind this: The 40 strike allows me to short 100 shares at 40. I paid $2.15 for the put, which makes my breakeven at 37.85. (40 minus 2.15 = 37.85).

In other words, I will make more money the lower the stock goes.

I won’t put all the blame of the struggling restaurants on the Amazon effect. Rising minimum wages is also a likely contributor to the struggles. However, every time you go to your front door, and pick up your new Amazon package, remember that you didn’t visit a mall to purchase that new shirt.

And after not shopping at that mall, you didn’t eat at a restaurant afterwards.

Options Education: Time Decay

Options Education: Time Decay

All options are a wasting asset whose time value erodes to zero by expiration. This erosion is known as time decay. Every day of an option’s “life,” it loses value as the time it has to finish in-the-money passes.

Decay

That said, let’s turn our attention to the calendar. The stock market will be closed on Monday, September 4 for Labor Day. This means that we have a three-day weekend. So what does this mean to options?

Over the course of the next couple of days, the market makers, or more likely their computer systems, are going to “push the date ahead” in all their products. So in the market makers’ pricing models, tomorrow’s date won’t be September 1, it’s more likely to be September 5th.

As we get closer to this weekend, the computer models will move the date to September 5, which is the day the market opens after the holiday. The models do this to price in the decay of the day off for the holiday. That means that they will take virtually all of the decay out of the options ahead of time, so that they aren’t stuck being the buyer of decaying assets over a long weekend.

So how do we profit from this phenomenon? By selling options or option spreads.

When we sell options, we are trying to capture the option decay as we are short a decaying asset.

Option Order Flow

When I was a trader in the pits on the Chicago Board of Options Exchange (CBOE), I learned very early to stay out of the way of the smart traders at Goldman Sachs and Morgan Stanley. For example, when a Goldman Sacks broker came running into my pit screaming that he needed a market on XYZ calls, I figured that something was up. And more often than not, either later that day, or in the days to come, an upgrade on the stock or a bullish corporate action would be announced.

I hate to be the bearer of bad news, but hedge funds and banks trade on insider information all the time. It is a reality. So I try to level the playing field for my readers by following into similar trades.

Insider Information

Take for example a recent trade I recommended for the subscribers of Cabot Options Trader. I had never heard of Macerich (MAC). But my scanner picked up on unusual options activity and drew my attention to the stock.

This is the alert that I sent to my Cabot Options Trader readers:

Buy Macerich (MAC) April 85 Calls (exp. 4/17/2015) for $2.60 or less.

I am not too familiar with Macerich (MAC). However this stock has seen extremely odd options trading for the past several weeks. On 2/20, a trader bought 5,000 March 90 Calls for $0.70. Then on 2/26, a trader bought another 4,000 of these calls for $0.40.

And today, a trader bought another 4,000 for $0.55. These trades don’t make sense with the stock trading at 83 and only three weeks until expiration. This type of activity really grabs my attention.

To execute this order, you need to:
Buy to Open the MAC April 85 Calls.

We were able to buy our calls for $2.50 shortly after my alert was sent.

So how did this trade work out? Here’s what I sent to my readers just four days later:

Macerich (MAC) Update: Potential Takeover

It was reported last night that Simon Property Group (SPG) has made approaches to take over Macerich (MAC), which would combine the two largest shopping-mall owners in the U.S. This would clearly explain the extremely bizarre options trades that brought us into our MAC April 85 Calls position. MAC is bid higher by $5 in pre-market trade at $88.80.

In the days that followed, we sold half the position for $5.10 for a profit of 104%, and the second half for $7.40 for a profit of 196%.

These insiders won’t always be right with their large call and put purchases, and we get some trades wrong from time to time. However, my “order flow reading” trades in just the last two months have netted some big scores for both my options trading services.

For example, Cabot Options Trader subscribers recently gained 110% in Utilities ETF (XLU) puts, 21% in Applied Materials (AMAT) calls and 24% in JD.com (JD) calls.

And Cabot Options Trader Pro subscribers locked in 157% in the Utilities ETF (XLU) bear put spreads, 64% in an E*Trade (ETFC) diagonal spread and 24% in JD.com (JD) calls.

2016

I’ve been on a great streak lately, but I missed out on a giant score recently, too. Nobody’s perfect.

On Tuesday March 11, 2015, I included two trades from Kraft Foods (KRFT) in my Daily Watch List that I send to my readers every morning before the market open. Here were those trades:

Buyer of 3,500 Kraft Foods (KRFT) March 62.5 Calls for $0.40

Buyer of 10,000 Kraft Foods (KRFT) June 67.5 Calls for $0.70

As always, I kept tabs on the stock, and was waiting for another round of call buying. That second wave never came, and the 3,500 March 62.5 Calls expired worthless. Because of a lack of continued call buying and the shorter-dated calls expiring for a 100% loss, I took the stock off of my radar.

Then last week, it was announced that Heinz and Brazilian private equity firm 3G Capital would acquire KRFT. In reaction to this news, KRFT traded higher by 42% to 87.00.

The 10,000 June 67.5 Calls purchased for $0.70 were worth $19.70, or a profit of $19,000,000 in approximately two weeks. Time and time again time, my theory that traders use options to trade on insider information is proven true.

And with the assistance of my proprietary scanning tool, we can get an inside view of what they’re doing.

Your guide to successful options trading,

Jacob Mintz

Covered Calls on Best Dividend Stocks for 2017

dividend

On Tuesday morning, Cabot Dividend Investor chief analyst Chloe Lutts Jensen released her Best Dividend Stocks for 2017. Her recommendations were U.S. Bancorp (USB), which yields 2.1%, and Caterpillar (CAT), which yields 3.1%.

But if you employ an options strategy, you can significantly boost those yields—to 4.3% and 5.9%, respectively!

I give you all the details below, but first, let’s review what Chloe said about USB and CAT.

Our Best Dividend Stocks for 2017

“Interest rates are starting to rise, and higher profitability for USB won’t be far behind. In the meantime, investors can collect a 2.1% yield thanks to USB’s reliable dividends, which the bank has paid since 1998 and increased every year since 2011.

“Caterpillar has paid dividends since 1925, and has increased the dividend annually for seven years running. At the current price, the dividend yields a solid 3.1%.”

So how can we bump up the yields from 2.1% to 4.3% and 3.1% to 5.9%? By selling covered calls against those high paying dividend stocks.

CAT

How Covered Calls Work

A covered call is a strategy in which the trader holds a long stock position and sells a call option on the same stock in an attempt to generate income. For every 100 shares of stock you own, you can sell one call. If you own 500 shares of stock, for instance, you can sell five calls.

A covered call is a VERY conservative strategy that requires no margin. It’s a great way to create yield and lower your cost basis on your stock position. (The downside is that you give up the potential for explosive upside gains.)

In my opinion, covered calls (also called buy-writes) should be a core strategy for all investors. At Cabot Options Trader and Cabot Options Trader Pro, we always hold a couple of covered call positions to give us slow and steady gains each and every month. Currently, we have covered calls in Blackstone (BX), United States Oil ETF (USO) and Calpine (CPN).

So how might we combine Chloe’s recommendations of USB and CAT as the best dividend stocks for 2017 with a covered call strategy?

If we bought 100 shares of CAT today at 96.80, we could sell one CAT January 115 Call at $2.65 (expires in January 2018).

And because each one call represents 100 shares of stock, the $2.65 that we sold the call for is actually $265, which we collect.

Here’s the breakdown on the upside and downside to this position:

The most we can make on this trade is $2,393 per covered call if the stock closes at 115 or above on January expiration (January 19, 2018). I get to $2,393 by adding the stock gain of $18.20 plus the dividend and covered call, times 100 shares. This would give us a yield of 24.8 % in 12 months’ time.

However, if CAT were to trade above 115 on January expiration, we would be taken out of our stock and call position by the trader who bought our call. (This is the negative part of covered calls … your upside is limited.)

If the stock price is unchanged (still 96.80) on January expiration, the combination of the dividend collected over the next 12 months and the sold call will have created a yield of 5.9% in 12 months’ time.

The combination of the dividends collected over the 12 months and the call we sold places our breakeven at 91.07.

Covered Calls

Similarly, if we bought 100 shares of USB today at 52.85, we could sell one USB January 60 Call for $1.20.

Here’s the breakdown of the upside and downside to this position:

The most we can make on the trade is $947 per covered call if the stock closes at 60 or above on January expiration (January 19, 2018). This would be a yield of 17.9% in 12 months’ time.

However, if USB were to trade above 60 on January expiration, we would be taken out of our stock and call position by the trader who bought our call.

If the stock is unchanged (still 52.85) on January expiration, the combination of the dividend and the sold call will have created a yield of 4.3% in 12 months’ time.

The combination of the dividend collected over the next 12 months and call sold puts our breakeven at 50.53.

As you can see from the examples above, covered calls are a great way to create yield and reduce your breakeven on a position—and not just on Chloe’s best dividend stocks for 2017!

Here are some recent covered call successes and failures for subscribers to Cabot Options Trader:

AMD covered call yield of 9.37%

MU covered call yield of 9.33%

GT covered call yield of 6.46%

And even when a trade goes bad like our CPE covered call (which dropped 11%), we only lost 1.44% because we sold a call to lower our breakeven.

If you have never traded covered calls before, I recommend that you first choose a stock in which you own at least 100 shares and sell one call against it. So even if you own 1,000 shares of Facebook (FB), I recommend that you sell just one call in order to learn how the strategy works.

Once you become familiar with the strategy, you can execute more covered calls. By adding this strategy to your investing arsenal, you can create more yield for your portfolio every month.

Why I Bought $SPY Puts

In the last several weeks, I have been growing more and more concerned with the market. I had a hunch that the market was due for a fall, and so I added S&P 500 ETF (SPY) put options to my Cabot Options Trader portfolio.

What did I see that had me concerned about the market?

Earnings season was turning into a mess. Companies that beat earnings were rewarded with small share price gains. Companies that met expectations, saw their shares fall a couple percent. And if a company missed expectations, the selling would often drive these stocks down 10%-20%. Here is a small list of those stocks that got punished.

Applied Optoelectronics (AAOI) down 33%
Unisys (UIS) down 29%
Coherent (COHR) down 20%
Ultimate Software (ULTI) down 14%
Teva Pharmaceutical (TEVA) down 36%

Good news was no longer being rewarded. And bad news was punished brutally. This was my first warning sign.

warning

My second big concern was the lack of conviction in options trading. For weeks, the big market players had been quiet. No longer were they buying high conviction calls in market titans such as Facebook (FB) and Goldman Sachs (GS). Instead, what little option activity my unusual option scanner was picking up on was targeting earnings plays. And when the market is strong, options traders usually load up on calls, so the silent activity was notable.

And lastly, while the headlines read “Dow All-Time Highs”, I knew that most of the market was in fact not moving, and in many respects, was actually weakening. And I told my readers several times, I could feel that under the surface, the sellers were potentially taking over, as “risk on” sectors such as Semiconductors (SMH), Biotech (IBB) and the Russell 2000 (IWM) were under pressure.

These three inputs combined had me concerned.

Now was I so sure that the market was going to fall that I jumped wildly onto the short side, and sold all my bullish positions? No. I am never so sure of myself that I go all-in. Instead, I wasn’t adding more bullish positions to the portfolio, even as the headlines read “New All-Time Highs!”

And given my concerns, and with the Chicago Board of Options Exchange Volatility Index (VIX) at all-time lows, the price of buying put options, betting the market would go lower, was too good to pass up.

Risk Reward

Here was the trade alert I sent to my Cabot Options Trader readers on Friday, August 4, just days before the market fell, detailing my thoughts on the state of the market, and why we were buying put options.

Buy S&P 500 ETF (SPY) January 240 Puts (exp. 1/2018) for $5.50 or less.

The market is in an interesting spot.

The Dow seems to make new highs every day, the long-term trend is clearly up, and every time there’s a negative headline from Washington D.C. or globally, the bulls immediately buy the shallow dips. This is clearly bullish.

However, below the surface, a lot of stocks have been struggling recently. The Russell 2000 (IWM), Semiconductors (SMH) and Biotechs (XBI), which are considered “risk on,” are all losing steam. The list of stocks that have fallen by 10% to 20% on earnings in the last two weeks is extremely long. And the list of stocks that blew away earnings, yet fell, is also growing. At least for now, good news is not being rewarded, and bad news is getting punished.

With the VIX again below 10, the price is again just too good to pass up for portfolio insurance for the next 168 days.

To execute this trade, you need to:

Buy to Open the SPY January 240 Puts.

As is always the case when I send a trade alert, I give a price that is easily achievable for my readers. And we were filled on that put buy at $5.31.

The following Tuesday the S&P 500 made a new all-time high, but then reversed to close lower on the day. And then, a couple days later, the S&P and Nasdaq fell by 1.45% and 2.13%, respectively.

The next day, Friday, five trading days after our put purchase, I sent this trade alert, selling half of our puts for a quick 35% profit.

Sell Half of Existing Position: Sell HALF your S&P 500 ETF (SPY) January 240 Puts for $7.20 or more.

The S&P 500 fell by 1.4% yesterday, and the Nasdaq dropped 2.13%. And with that market drop, the VIX soared 44%.

I am going to sell half of my hedge today.

To execute this trade you need to:

Sell to Close HALF your SPY January 240 Puts.

What comes next for the market in the coming days is anyone’s guess. However, for now, I am going to hold half of my put options. And as always, I will be watching option order flow, as well as the strength in leading sectors, to give me my next cue.

Your guide to successful options trading,

Jacob Mintz

 

Why Weekly Options are Like Gambling

CHICAGO, IL - SEPTEMBER 18:  Traders signal offers in the Standard & Poor's 500 stock index options pit at the Chicago Board Options Exchange (CBOE) following the Federal Open Market Committee meeting on September 18, 2013 in Chicago, Illinois.   Federal Reserve policymakers unexpectedly voted today to continue its bond-buying stimulus program causing an immediate spike in the markets.  The Fed also said it would keep short-term interest rates near zero.  (Photo by Scott Olson/Getty Images)

When I was a young hotshot, trading on the floor of the Chicago Board of Options Exchange (CBOE), I would make markets in Google (GOOG) and Bank of America (BAC) in the morning, and some days, jet off to Las Vegas to play poker, craps and blackjack in the evening. Those were the days of my youth.

This past weekend, I turned 40, and with two young kids at home, gambling on the stock market and at casinos is no longer part of my life.

There’s a common misconception that options trading is like gambling. I would strongly push back on that. In fact, if you know how to trade options or can follow and learn from a trader like me, trading in options is not gambling, but in fact, a way to reduce your risk.

That said, I do think that trading weekly options is comparable to walking up to the roulette table in Vegas, choosing a random number, and hoping for a long shot to come through.

casino

Regular Options vs. Weekly Options

So what are the differences between regular options and weekly options?

In 1973, the Chicago Board of Options Exchange introduced call options. A couple of years later, the CBOE introduced put options. These “regular” call and put options expire on the third Friday of each month. A regular option has at least one month, and often three, six or 12 months until it expires.

In 2005, as options trading became more and more popular, the CBOE created “weekly” options. These options are exactly like regular options, except they exist for only eight days. They are created every Thursday and they expire eight days later, on the following Friday.

The short life of these options is the critical component of weekly options. Because they only exist for a few days, you can buy and sell them for extremely cheap prices. And those cheap prices can create some huge winners and some huge losers.

For example, if I was bullish on Microsoft (MSFT), which is trading at 65.40 and will report earnings on Thursday, April 27, I could get bullish exposure by using either weekly options, or regular options.

Let’s take a look at two trades.

Weekly Options:

Buy Microsoft (MSFT) April 67.5 Calls (expiring Friday, April 28) for $0.60.

This trade has eight days until it expires.

My options trading model has the odds of the stock trading at 67.5 next Friday at 20%.

  • If MSFT does not close at 67.5 or above on April 28, you’ll lose your entire premium—$60 per call that you bought.
  • If MSFT trades at 68.10 on April 28, you will break even on the trade.
  • If MSFT trades above 68.10 on April 28, you will make $100 for every $1 the stock trades above 68.10.

The intriguing component of weekly options is that the price of the option is pretty cheap at $0.60. This low price can make weekly options a decent trade for binary events, such as drug trials. And for some traders willing to gamble, weekly options can offer a decent risk/reward into MSFT earnings, though it would require an approximate 4.5% move in the stock for the traders to profit.

Regular Options:

Buy Microsoft (MSFT) July 67.5 Calls (expiring Friday, July 21) for $1.60.

This trade has 94 days until it expires.

My options trading model has the odds of the stock trading at 67.5 on July 21 at 45%.

  • If MSFT does not close above 67.5 on July 21, your entire premium is lost—$160 per call purchased.
  • If MSFT trades at 69.10 on July 21, you will break even on the trade.
  • If MSFT trades above 69.10 on July 21, you will make $100 for every $1 the stock trades above 69.10.

While you are paying more for this regular option, you have much more time for the stock to rally and profit than if you bought the weekly option. And that added time gives you a 25% greater chance of making money on the trade vs. the weekly trade.

When judging how you want to play a stock with options, at the end of the day you need to ask yourself if you are a gambler willing to take the risk on a long shot, or are you willing to pay more for better odds of success.

As I’ve become older and my risk tolerance has dropped, I’ve come to favor slow and steady, high-probability trades.

Three Day Rule – Trading Stock Disasters

I began my career on the floor of the Chicago Board of Options Exchange in 1999 straight out of college. For a year, I stood next to two trading legends, soaking up all of their wisdom as their clerk. That year, the market ripped higher as virtually every dot-com stock exploded higher day after day. I learned a great deal during that bull run.

Then, soon after I became a trader myself, the Nasdaq fell apart. The dot-com bubble burst, and valuations were reset for virtually the entire market. During those bearish years, I learned even more than during the bull market of the previous years.

And one rule that I took away from the bear years is about stocks that have taken a big dive.

The old trading rule that was hammered into my brain by my two trading legend mentors was this:

If a stock took a big fall, whether it was on earnings or some other news event, you MUST wait at least three trading days before even thinking about putting on a bullish position.

The rationale behind this theory is that if a large hedge fund or institution owns millions of shares of a stock, it won’t be able to sell out of their entire position in a day or two without causing the stock to fall.

Instead, the institution will parcel out its sales over a couple of days, so they don’t depress the stock so much that they sell at bad prices.

For example, let’s take a look at LinkedIn (LNKD), which fell from 192 to 108 on February 5 on a disappointing earnings release. That was a staggering fall! The next day, the downgrades came pouring in from the brokerage houses (thanks for the downgrades after the fall!).

Based on the three-day trading rule, I wouldn’t consider adding a bullish position on Friday February 5, Monday February 8 or Tuesday February 9. But on Wednesday February 10, according to the rule, I could begin to think about adding a bullish position.

Here are LNKD’s closing prices on the day of its earnings report and the following days:

lnkd chart

 

chart-2-2-23-16

As you can see, there remained selling pressure on the stock in the three days after the big drop. Then, slowly but surely, the stock stabilized, and buyers began to take back over.

And one last thought on this theory … you must be willing to miss buying the bottom if you stick to the 3 day rule. However, over time, seasoned traders know that more times than not, the selling pressures don’t dissipate in hours, and often times take days.

To learn more about OptionsAce please visit http://optionsace.com/

Bear Call Spread

Bear Call Spread

A Bear Call Spread is is an options strategy used when a decline in the price of the stock/index is expected, or a significant move higher is unlikely.

This strategy involves the selling of a call at a lower strike price while simultaneously buying a call at a higher strike price. The maximum profit on this strategy is the premium you collect. The maximum loss is the difference between the strikes minus the premium you collect.

Let’s say stock XYZ is trading at 90. You will theoretically sell the 100/105 bear call spread for $1. To execute this trade you would:

Sell the 100 calls

Buy the 105 calls

For a total credit of $1.

Here is the graph of this trade at expiration.

Bear Call Spread

As you can see, as long as the stock stays below $100 by expiration, you will collect the $1 in premium, or $100 per spread sold. If the stock goes to 105 or above, your losses are capped at $4, or $400 per spread sold.

This is a strategy I always have in my personal portfolio. I know that I am long enough stocks, that if I sell an out of the money call spread, perhaps 5-6% out of the money, I would be thrilled if I lost on this spread, as the market, and my other positions have gained 5-6% along the way.

To learn more about OptionsAce please visit http://optionsace.com/

Option Terminology

What is an Option?
An option is a contract that allows you to buy (call option) or sell (put option) a certain amount of an underlying stock (usually 100 shares unless adjusted for a split or other corporate action) at a specific price (strike price) for a set amount of time (any time prior to its expiration).

What are Calls Puts

Call Option
A Call option gives the buyer the right to buy 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a call option is obligated to sell the stock at the strike price if the option is exercised.

Put Option
A Put option gives the buyer the right to sell 100 shares at a fixed price (strike price) before a specified date (expiration date). Likewise, the seller (writer) of a put option is obligated to purchase the stock at the strike price if exercised.

Strike (or Exercise) Price
The strike price is the price per share at which the holder can purchase (for Call options) or sell (for Put options) the underlying stock.

buy sell

Exercise
Exercise is the process by which an option buyer (holder/owner) invokes the terms of the option contract. When exercising, Call owners will buy the underlying stock, while Put owners will sell the underlying stock under the terms set by the option contract. All option contracts that are in-the-money (i.e. have at least one cent of intrinsic value) at expiration will be automatically exercised.

Expiration Date
The expiration date is the last day on which the option may be exercised. Monthly listed stock options cease trading on the third Friday of each month and expire the next day. Weekly options cease trading on Friday of that week.

Hedging
Hedging is a conservative strategy used to reduce investment risk by implementing a transaction that offsets an existing position.

Covered Call
A covered Call is another risk-reducing strategy; in this, a Call option is written (sold) against an existing stock position on a share-for-share basis. The call is said to be “covered” by the underlying stock, which could be delivered if the call option is exercised.

Intrinsic Value
The price of an option is made up of two parts, the intrinsic value and the time value. The intrinsic value of an option is the amount of profit that can be theoretically obtained if the option is exercised at that moment and the stock either purchased (for calls) or sold (for puts) at the current market price. If an option has positive intrinsic value, it is said to be “in-the-money” (ITM) and if it has negative intrinsic value it is said to be “out-of-the-money” (OTM). For instance, an XYZ May 25 Call priced at $3.00 when the stock is trading at $26.50 would have $1.50 of intrinsic value if the stock were trading at $26.50, regardless of its market price at the time.

Time Value
Time value is the amount by which an option’s market price exceeds its intrinsic value. In the case above with the XYZ May 25 Call priced at $3.00 while XYZ stock is trading at $26.50, the intrinsic value is $1.50 and the rest is time value, in this case, the remaining $1.50 is time value. If an option is out-of-the-money (i.e. has no intrinsic value) then the entire market price is considered time value or time premium.

Premium
The price of an option is called its premium. Prices are quoted per share, but premium is usually the entire dollar value of the contract (Price per share X 100 shares = total premium).

time and money balance sign

Time Decay
Because options have an expiration date, the time value gradually erodes all options are wasting assets whose time value erodes to zero by expiration. This erosion is known as time decay. The closer an option is to expiring, the greater the erosion in value. Time value varies with the square root of time, so that as an option approaches its expiration date, the rate of time decay increases.

Long
To be “long” an option simply means to have purchased it in an opening transaction and thus to own or hold it in a stock or an option.

Short
Being short has two meanings. If one is short a stock, this means they have sold shares they do not own. To be short an option simply means to have sold the option and collected the premium in an opening transaction. (A short position is carried as a negative on a statement and must be purchased later to close out.)

LEAPS (Long-term Equity AnticiPation Securities)
These are long-term options with expiration dates as far out as three years, usually expiring in January.

To learn more about OptionsAce please visit http://optionsace.com/

Option Volatility and Decay

One of the most important inputs for pricing options is volatility.  And when I speak of option volatility, I’m sure for some readers it’s a difficult concept to grasp.  When thinking about option volatility just think of supply and demand.  If there are lots of buyers of an asset the price will likely go up. If there are lots of sellers of an asset, the price will go down.

Yesterday there was a great example of volatility getting “bid up” in Molson Coors Brewing (TAP).  Volatility is high already in TAP as there is speculation of a corporate action and call buying has been aggressive.  I was debating entering into a position for our portfolio.

At the time I began looking at the stock I was targeting the July 75 calls as the stock was trading at 74.  The market on these calls was $4.60 – $4.90.  As I was formulating my opinion a trader came in and bought 2,500 of the May 90 calls, 2,500 of the July 100 calls, and 2,500 of the May 77.5 calls.

Because of these call purchases, volatility in TAP options went CRAZY.  The July 75 calls that I was looking at went from $4.60 – $4.90 to $5.50 – $5.90 in about two minutes, with the stock hardly moving.  That is a prime example of supply and demand and the effect it can have on volatility/price of an option.

Conversely let’s talk about what this upcoming long weekend means to options, and how most options will begin to lose value at a rapid rate.

All options are a wasting asset whose time value erodes to zero by expiration. This erosion is known as time decay. Every day of an option’s “life,” it loses value as the time it has to finish in-the-money passes.

That said, let’s turn our attention to the calendar. The stock market will be closed on Friday, April 3rd for Good Friday. This means that we have a three-day weekend. So what does this mean to options?

Over the course of the next couple of days, the market makers, or more likely their computer systems, are going to “push the date ahead” in all their products. So in the market makers’ pricing models, today’s date today isn’t April 1st, it’s more likely to be April 3rd.

As we get closer to this weekend, the computer models will move the date to April 6th, which is the day the market opens after the holiday. The models do this to price in the decay of the day off for the holiday. That means that they will take virtually all of the decay out of the options ahead of time, so that they aren’t stuck being the buyer of decaying assets over a long weekend.

So how do we profit from this phenomenon? By selling options or option spreads.

When we sell options, we are trying to capture the option decay as we are short a decaying asset.

That being said, if the computer models push the date ahead too far on Thursday, I may take advantage of the cheap option prices and be a buyer of some options.

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