Learn This Lesson Once and Profit Many Times Over
by Chris Rowe 08/07/09
Free Trading Guides
Time Flies ... and Can Take Your Premium Away With It
If you want to benefit from this feature, you should trade the options that have at least three months left before the expiration day. If you hold the Cisco options for a few months, and you realize that expiration day will be in three months, then what you should do is sell the calls that you own, and buy the calls with an expiration day that's further out. This way, you can keep your call options gaining more and losing less.
Here, it's easy to see one of the benefits of owning call options that are in-the-money. But what about the time factor?
Well we already know that anything that's out-of-the-money would be worthless at expiration.
If Cisco traded flat until expiration, the Jan 30 Call and the Jan 27.50 Call, which are out-of-the-money, would lose all value. The Jan 25 Call would be at $1.68 (the in-the-money amount, aka, intrinsic value).
However, our Jan 20 Call, which was trading at $6.97 and only had 92 cents of extrinsic value, would be at $6.28. (Again, the intrinsic value of $6.28 is not affected by time decay.) So, a very small percentage of the investment, relative to the other two (Jan 30 and Jan 25), was affected by time decay.
We've covered the impact on the Cisco options if the stock moved today. We've covered what would happen if the stock didn't move at all until expiration. But what would happen to the options in six months from now if the stock moved 5 points higher, 5 points lower, or traded at the same price that it started at ($26.28)?
Here's where the options would trade:
|
Call Option
|
Original Price
|
CSCO remains at $26.28
|
CSCO up 5 at $31.28
|
CSCO down 5 at $21.28
|
|
Jan 17.5
|
$9.17
|
$8.80 (-$0.37)
|
$13.98 ($4.81)
|
$3.97 (-$5.20)
|
|
Jan 20
|
$6.97
|
$6.33 (-$0.64)
|
$11.30 ($4.33)
|
$1.93 (-$5.04)
|
|
Jan 22.5
|
$4.99
|
$3.98 (-$1.01)
|
$8.80 ($3.81)
|
$0.64 (-$4.35)
|
|
Jan 25
|
$3.47
|
$2.00 (-$1.47)
|
$7.22 ($3.75)
|
$1.05 (-$2.22)
|
|
Jan 27.5
|
$2.10
|
$0.78 (-$1.32)
|
$4.04 ($1.94)
|
$0.02 (-$1.05)
|
|
Jan 30
|
$1.34
|
$0.23 (-$1.11)
|
$2.21 ($0.87)
|
$0.00 (-$1.34)
|
The options above illustrate the impact of Cisco's stock price on the options, assuming that there are only 60 calendar days left before expiration.
See the difference?
This is why I prefer to exit the long option position at least three months before the expiration day. If you want to benefit from the reduced risk of the stock trading lower, you might want to play it this way, too.
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