Since trading in index and stock options began in June/July 2001, many traders have been attracted to trading in options.
The two aspects of trading in options are: Buying options and selling or writing options.
When we buy options, we are paying for time premium and in return we obtain limited risk and unlimited reward on the options purchased. When we sell options we are receiving time premium but in return we accept unlimited risk on the options sold accompanied by limited reward.
For the risk-averse investor, buying options provides a low risk method of participating in the options market.
But when we buy options, we are paying for time premium. Time premiums suffer from time decay. This means, as time goes by, the premium on the option comes down even if the underlying prices remain the same.
Hypothetical Example:
Date: May 2, 2002
Satyam is trading at 260
The 260 call expiring on May 30 is priced at 15.00
Date: May 16, 2002
Satyam is trading at 260
The 260 call expiring on May 30 is priced at 10.00
We see that the price of the option has come down from 15 to 10 even though the price of Satyam has remained the same.
This happens due to the concept of time decay. As the date of expiration comes closer, the probability of making a profit from the option comes down.
Most of the time, the buyer of options ends up as a loser even when he makes a correct call on the direction of the option. This happens because the value of this option falls due to the effect of time decay. Even if the underlying stock makes a move in her favor, the detrimental effect of time decay may more than offset the positive benefits of the move by the stock.
Buying Time Premium
As a buyer of options, we want to identify periods or situations when the premium paid on our options should be subjected to the minimum of time decay. We want to buy premium (we actually buy premium when we buy options) only if we find a low risk buy zone. This applies to both calls and puts.
Buy Premium Strategies.
The "Buy Premium" strategies are essentially "hit and run" techniques. The "hit and run" nature of these strategies is due primarily to the detrimental effect of time decay on option premiums. The longer an option position is held, the more time premium will decrease. In other words, the longer you hold a position, the greater the eventual market movement must be in order to overcome the negative effects of time decay. As a result, the intent is generally to catch short-term swings in the market, rather than waiting (and hoping) for an extended movement in the Underlying price.
We will discuss strategies that will try to:
01. Identify short-term movements in the market;
02. Get in just before a significant market movement;
03. Take profits quickly (within 2 to 10 trading days).
04. Maintain a stop loss if the trade goes wrong.
These strategies will be discussed in subsequent issues.
