Exit is more important than entry for Long Options trade
Option buyer’s expectation
If you are an option buyer two things have to happen for you to make money:
- Underlying stock must move in your favor and
- Must move beyond the strike price within certain time
As the delta of an option keeps decreasing, probability of being in the money at the time of expiration also keeps decreasing.
Option price consists of two values:
- Intrinsic Value and
- Extrinsic Value.
Intrinsic Value is the money you would get for an option at the time of expiration. It is a measure of how much “In The Money (ITM)” option is.
Extrinsic Value = Price of an Option - Intrinsic Value
When an option is At The Money (ATM) or Out Of The Money (OTM) the value option represents only Extrinsic Value. On the contrary, when an option is Deep In The Money (DITM) the value of the option will represent only Intrinsic Value.
When we talk about Theta or Time Decay of an option, we are talking about slow erosion of extrinsic value of an option.
As you can see, time decay is working against an options buyer - sooner an option trade is closed it is better.
So here is an approach to trading long options:
- Wait for a move in particular direction to start
- Buy an option - Put or Call
- If the underlying starts moving favorable exit the trade at certain percentage of profit
- If the move does not materialize initiate time based exit. Say at the end of the day or after 120 minutes whatever suits. Don’t wait too long for the move to happen.
- If the move does not materialize and the underlying reverses, close the option position as there is no reason to keep the position open.