Stock Option Decay is Nasty!

by JT McGee

Late last year I purchased Ford call options at the $10 strike for an average price of $1.95. Europe was in meltdown, and every investor was flipping out about the long-term prospects for the US automotive industry.

American auto companies, like most large companies, also have large-scale European operations. A slowdown in Europe would mean fewer car sales. For a company with high operating leverage like Ford, any reduction in total sales brings a larger reduction in total profit.

I laid out my macro case for buying Ford in an article about the macro-environment surrounding the American auto industry. Of course, an investment in Ford also required that it meet my standards for relative price to value, but the macro environment is what got me interested in the stock to begin with.

In Options We Trust

Stock options are the bee’s knees for investments where you feel adamantly about future potential but have zero real margin of safety in the short-term. Ford, burdened by debt, unfunded future pensions, and with no real tangible equity to speak of, isn’t exactly good enough to fit in my Pawn Stars-style investment thesis. I like to buy companies when the company is mostly free – when I can buy so cheap that I essentially pay for the assets on hand.

The rationale is quite simple: I can beat the market so long as I never lose. An investment objective like “never lose” requires that I have to be ultra-selective in building equity positions in my favorite companies.

Why I Buy Options

Options are most exciting to me when there is no inherent margin of safety in the equity of a particular company. If you buy a firm only on the prospects for future earnings, there is nothing to backstop its price on the market at any given time. If earnings go into the ground for a quarter, the stock dives and there are no real current assets to give the company any inherent value.

Stock options allow me to limit my downside in firms that are not up to par with my stock selection criteria. By purchasing January 2013 calls at the $10 strike price, my risk was limited to $1.95 per share. Even if Ford stock fell from roughly $10 then to $5, I would stand to lose only $1.95.

I would lose on the commission paid for the trade as well, but you can typically avoid commissions with promo codes. Take a look at the $100 sign-up bonus optionXpress promo code to see just how much brokers are willing to subsidize your trades.

Decay is a Killer

Option decay brings about a very serious problem with options investing: you get what you pay for. As time goes on, the value of any option will decline as the expiration date nears. For example, in late Autumn I paid $1.95 for Ford calls at the $10 strike while Ford traded for ~$10 per share, essentially saying to the market that I believed Ford would sell for more than $11.95 by the expiration date.

Today, those same options at the $10 strike are worth $3 each, up from $1.95. However, Ford stock now trades for just over $12.50 per share.

It’s clear how I lost on this trade, even if I have thus far managed a return of 50%. In autumn, my options had about $.50 of intrinsic value (I think Ford was like $10.50 that day) and $1.45 of premium. Today, the same options have $2.50 in intrinsic value, and $.50 of premium. Unfortunately for me, the options are not as valuable because there is less time today, in March, than there was in September for a major move higher.

Also, implied volatility dropped substantially in that time. Investors no longer expect major moves up and down as they had in Autumn 2011. An efficient market prices expected volatility into the options. If volatility falls, so does the market value for any stock option. If volatility rises, so does the price for any stock option.

Just think if volatility stayed constant, and time had never passed. My options might be worth some $4.50 each, since the option would not have experienced time and volatility decay.

Getting Started With Options

I think most anyone would really benefit from some exposure to the options market. While options are typically regarded as higher-risk, the truth is that options can significantly decrease risk in your portfolio. Options can be used effectively in finding opportunities that you might otherwise pass up.

Unfortunately, not all brokers are the same. Pending that you already have a brokerage account, you can probably trade options through your existing broker. I would certainly look at the commission schedule for your broker before you do. Discount brokers are not created equal when it comes to option commission pricing.

And of course there are ways to do it frugal. There’s an optionsXpress promo code for a $100 sign-up bonus. E-Trade used to have a few offers on options, and I’m fairly sure that even larger brokers like InteractiveBrokers have promotions or split-level pricing depending on your account balance.

Photo by: Hannibal Poenaru

{ 5 comments… read them below or add one }

Darwin's Money March 15, 2012 at 22:23

I used to buy a lot of out of the money options and they’d expire worthless. Of course, I bought Overstock.com puts at $5 bc the company is shit and when the stock didn’t decline I sold them at a loss – and now the company’s imploding and approaching $5 so they’re worth 5x what I bought them for.

But nowadays, for the most part, I sell options. I sell out of the money calls on QQQ now and then since I’m long stocks and just let it expire (or more recently, had to buy back), but sell puts on UGA to hedge my gas prices – they have expired worthless every time and I keep rolling the same trade quarterly.

Since most options contracts expire worthless I try to use decay to my advantage and make a few bucks a day instead of going for the huge payday on the long side.

Reply

JT McGee March 15, 2012 at 23:16

But, but, but Overstock was going down because of short-sellers! I love the OSTK CEO, so delusional.

Interesting strategy with selling the OTM calls. I would like to do that, but I just can’t justify owning a stock and then betting that it won’t go up. It just doesn’t make sense to me. I know people do well with covered calls, but it’s like the anti-everything in my investment thesis.

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PK March 15, 2012 at 22:35

To clarify, does “never lose” mean you never take a loss? I can see that ending poorly if you continue to throw good money after bad… perhaps you mean “rarely lose”, haha.

You know my strategy: mostly stocks, use options as an indicator. Options expiration day tomorrow so I’ve got to do some March predictions!

Reply

JT McGee March 15, 2012 at 23:14

Never lose, rarely lose – it’s all the same! No, really – best investment strategy is to assume you’re completely insane and price in a massive margin of safety. The application of frugality to investing is so rewarding! Never have I felt better about pricing in my own stupidity; it works well.

Same here on the mostly stock portfolio. I do tend to look to options activity when nearing earnings releases for any signs of a surprise. And options totally rock when I want limited downside and unlimited upside. Looking forward to the March predictions!

Reply

cashflowmantra March 16, 2012 at 09:12

I am with Darwin on this one. It is great to sell calls and collect the time premium decay. If I have to buy back, then doing so when the time value is negligible is what I do. At other times, I simply let it be called and re-enter the position later.

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