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The Importance of Time Value in Options Trading
Most investors and traders new to options markets prefer to buy calls and puts because of their limited risk and unlimited profit potential. Buying puts or calls is typically a way for investors and traders to speculate with only a fraction of their capital. But these straight option buyers miss many of the best features of stock and commodity options, such as the opportunity to turn time-value decay (the reduction in value of an options contract as it reaches its expiration date) into potential profits.
When establishing a position, option sellers collect time-value premiums paid by option buyers. Rather than losing out because of time decay, the option seller can benefit from the passage of time, and time-value decay becomes money in the bank even if the underlying asset is stationary.
Before explaining the importance of time value with respect to option pricing, this article takes a detailed look at the phenomenon of time value and time-value decay. First we’ll look at some basic option concepts that apply to the concept of time value.
Options and Strike Price
Depending on where the underlying asset is in relation to the option strike price, the option can be in, out, or at the money. At the money means the strike price of the option is equal to the current price of the underlying stock or commodity. When the price of a commodity or stock is the same as the strike price (also known as the exercise price) it has zero intrinsic value, but it also has the maximum level of time value compared to that of all the other option strike prices for the same month. The table below provides a table of possible positions of the underlying asset in relation to an option’s strike price.
|The Relationship of the Underlying to the Strike Price|
|In-the-money option||The price of the underlying is less than the strike price of the option.||The price of the underlying is greater than the strike price of the option.|
|Out-of-the-money option||The price of the underlying is greater than the strike price of the option.||The price of the underlying is less than the strike price of the option.|
|At-the-money option||The price of the underlying is equal to the strike price of the option.||The price of the underlying is equal to the strike price of the option.|
Note: Underlying refers to the asset (i.e. stock or commodity) upon which an option trades.
This table shows that when a put option is in the money, the underlying price is less than the option strike price. For a call option, in the money means that the underlying price is greater than the option strike price. For example, if we have an S&P 500 call with a strike price of 1,100 (an example we will use to illustrate time value below), and if the underlying stock index at expiration closes at 1,150, the option will have expired 50 points in the money (1,150 – 1,100 = 50).
In the case of a put option at the same strike price of 1100 and the underlying asset at 1050, the option at expiration also would be 50 points in the money (1,100 – 1,050 = 50). For out-of-the-money options, the reverse applies. That is, to be out of the money, the put’s strike would be less than the underlying price, and the call’s strike would be greater than the underlying price. Finally, both put and call options would be at the money when the underlying asset expires at the strike price. While we are referring here to the position of the option at expiration, the same rules apply at any time before the options expire.
Time Value of Money
With these basic relationships in mind, we take a closer look at time value and the rate of time-value decay (represented by theta, from the Greek alphabet). If we ignore volatility, for now, the time-value component of an option, also known as extrinsic value, is a function of two variables: (1) time remaining until expiration and (2) the closeness of the option strike price to the money. All other things remaining the same (or no changes in the underlying asset and volatility levels), the longer the time to expiration, the more value the option will have in the form of time value.
But this level is also affected by how close to the money the option is. For example, two call options with the same calendar month expiration (both having the same time remaining in the contract life) but different strike prices will have different levels of extrinsic value (time value). This is because one will be closer to the money than the other.
The table below illustrates this concept and indicates when time value would be higher or lower and whether there will be any intrinsic value (which arises when the option gets in the money) in the price of the option. As the table indicates, deep in-the-money options and deep out-of-the-money options have little time value. Intrinsic value increases the more in the money the option becomes. And at-the-money options have the maximum level of time value but no intrinsic value. Time value is at its highest level when an option is at the money because the potential for intrinsic value to begin to rise is greatest at this point.
|Intrinsic Value vs. Time Value|
|Put/Call||Time-value decreases as the option gets deeper in the money; intrinsic value increases.||Time-value decreases as option gets deeper out of the money; intrinsic value is zero.||Time-value is at a maximum when an option is at the money; intrinsic value is zero.|
Note: Intrinsic value arises when an option gets in the money.
In the figure below, we simulate time-value decay using three at-the-money S&P 500 call options, all with the same strikes but different contract expiration dates. This should make the above concepts more tangible. Through this presentation, we are making the assumption (for simplification) that implied volatility levels remain unchanged and the underlying asset is stationary. This helps us to isolate the behavior of time value. The importance of time value and time-value decay should thus become much clearer.
Taking our series of S&P 500 call options, all with an at-the-money strike price of 1,100, we can simulate how time value influences an option’s price. Assume the date is February 8. If we compare the prices of each option at a certain moment in time, each with different expiration dates (February, March, and April), the phenomenon of time-value decay becomes evident. We can witness how the passage of time changes the value of the options.
The figure below illustrates the premium for these at-the-money S&P 500 call options with the same strikes. With the underlying asset stationary, the February call option has five days remaining until expiry, the March call option has 33 days remaining, and the April call option has 68 days remaining.
As the figure below shows, the highest premium is at the 68-day interval (remember prices are from February 8), declining from there as we move to the options that are closer to expiration (33 days and five days). Again, we are simply taking different prices at one point in time for an at-the-option strike (1100), and comparing them. The fewer days remaining translates into less time value. As you can see, the option premium declines from $38.90 to $25.70 when we move from the strike 68 days out to the strike that is only 33 days out.
The next level of the premium, a decline of 14.7 points to $11, reflects just five days remaining before expiration for that particular option. During the last five days of that option, if it remains out of the money (the S&P 500 stock index below 1,100 at expiration), the option value will fall to zero, and this will take place in just five days. Each point is worth $250 on an S&P 500 option.
One important dynamic of time-value decay is that the rate is not constant. As expiration nears, the rate of time-value decay (theta) increases (not shown here). This means that the amount of time premium disappearing from the option’s price per day is greater with each passing day.
The concept is looked at in another way in the figure below: The number of days required for a $1 (1 point) decline in premium on the option will decrease as expiry nears.
This shows that at 68 days remaining until expiration, a $1 decline in premium takes 1.75 days. But at just 33 days remaining until expiration, the time required for a $1 loss in premium has fallen to 1.28 days. In the last month of the life of an option, theta increases sharply, and the days required for a 1-point decline in premium falls rapidly.
At five days remaining until expiration, the option is losing 1 point in just less than half a day (0.45 days). If we look again at the Time-Value Decay figure, at five days remaining until expiration, this at-the-money S&P 500 call option has 11 points in premium. This means that the premium will decline by approximately 2.2 points per day. Of course, the rate increases even more in the final day of trading, which we do not show here.
The Bottom Line
While there are other pricing dimensions (such as delta, gamma, and implied volatility), a look at time-value decay is helpful to understand how options are priced.
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Let’s consider the following statement. If it’s true that the market can only go up or down over the long-term, then using the most basic 1:1 risk/reward ratio, there should be at least 50% winners, shouldn’t there? Well, there isn’t. This article debates in favour of the notion that a trader is their own worst enemy, and that human error is at the root of most problems. In short, the main reason why Forex traders lose money is no rocket science. It’s the traders themselves.
Financial trading, including the currency markets, requires long and detailed planning on multiple levels. Trading cannot commence without a trader’s understanding of the market basics, and an ongoing analysis of the ever changing market environment. For those interested in investing and trading, read through the suggestions below and you will learn how to avoid losing money in Forex trading.
Overtrading – either trading too big or too often – is the most common reason why Forex traders fail. Overtrading might be caused by unrealistically high profit goals, market addiction, or insufficient capitalisation. We will skip unrealistic expectations for now, as that concept will be covered later in the article.
Most traders know that it takes money to make a return on their investment. One of Forex’s biggest advantages is the availability of highly leveraged accounts. This means that traders with limited starting capital can still achieve substantial profits (or indeed losses) by speculating on the price of financial assets.
Whether a substantial investment base is achieved through the means of high leverage or high initial investment is practically irrelevant, provided that a solid risk management strategy is in place. The key here is to ensure that the investment base is sufficient. Having a sufficient amount of money in a trading account improves a trader’s chances of long-term profitability significantly – and also lowers the psychological pressure that comes with trading.
As a result, traders risk smaller portions of the total investment per trade, while still accumulating reasonable profits. So, how much capital is enough? Here it is important to learn how to stop losing money in Forex trading due to improper account management. The minimum Forex trading volume any broker can offer is 0.01 lot.
This is also known as a micro lot and is equivalent to 1,000 units of the base currency that is being traded. Of course, a small trade size is not the only way to limit your risk. Beginners and experienced traders alike need to think carefully about the placement of stop-losses. As a general rule of thumb, beginner traders should risk no more than 1% of their capital per trade. For novice traders, trading with more capital than this increases the chances of making substantial losses.
Carefully balancing leverage whilst trading lower volumes is a good way to ensure that an account has enough capital for the long-term. For example, to place one micro lot trade for the USD/EUR currency pair, risking no more than 1% of total capital, would only require a $250 investment on an account with 1:400 leverage. However, trading with higher leverage also increases the amount of capital that can be lost within a trade. In this example, overtrading an account with 1:400 leverage by one micro lot quadruples potential losses, compared to the same trade being placed on an account with 1:100 leverage.
Trading addiction is another reason why Forex traders tend to lose money. They do something institutional traders never do: chase the price. Forex trading can bring a lot of excitement. With short-term trading intervals, and volatile currency pairs, the market can be fast paced and cause an influx of adrenaline. It can also cause a huge amount of stress if the market moves in an unanticipated direction.
To avoid this scenario, traders need to enter the markets with a clear exit strategy if things aren’t going their way. Chasing the price – which is effectively opening and closing trades with no plan – is the opposite of this approach, and can be more accurately described as gambling, rather than trading. Unlike what some traders would like to believe, they have no control or influence over the market at all. On certain occasions, there will be limits to how much can be drawn from the market.
When these situations arise, smart traders will recognise that some moves are not worth taking, and that the risks associated with a particular trade are too high. This is the time to exit trading for the day and keep the account balance intact. The market will still be here tomorrow, and new trading opportunities may arise.
The sooner a trader starts seeing patience as a strength rather than a weakness, the closer they are to realising a higher percentage of winning trades. As paradoxical as it may seem, refusing to enter the market can sometimes be the best way to be profitable as a Forex trader.
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Not Adapting to the Market Conditions
Assuming that one proven trading strategy is going to be enough to produce endless winning trades is another reason why Forex traders lose money. Markets are not static. If they were, trading them would have been impossible. Because the markets are ever-changing, a trader has to develop an ability to track down these changes and adapt to any situation that may occur.
The good news is that these market changes present not only new risks, but also new trading opportunities. A skilful trader values changes, instead of fearing them. Among other things, a trader needs to familiarise themselves with tracking average volatility following financial news releases, and being able to distinguish a trending market from a ranging market.
Market volatility can have a major impact on trading performance. Traders should know that market volatility can spread across hours, days, months, and even years. Many trading strategies can be considered volatility dependent, with many producing less effective results in periods of unpredictability. So a trader must always make sure that the strategy they use is consistent with the volatility that exists in the present market conditions.
Financial news releases are also important to keep track of, even if a selected strategy is not based on fundamentals. Monetary policy decisions, such as a change in interest rates, or even surprising economic data concerning unemployment or consumer confidence can shift market sentiment within the trading community.
As the market reacts to these events, there’s an inevitable impact on supply and demand for respective currencies. Lastly, the inability to distinguish trending markets from ranging markets, often results in traders applying the wrong trading tools at the wrong time.
Poor Risk Management
Improper risk management is a major reason why Forex traders tend to lose money quickly. It’s not by chance that trading platforms are equipped with automatic take-profit and stop-loss mechanisms. Mastering them will significantly improve a trader’s chances for success. Traders not only need to know that these mechanisms exist, but also how to implement them properly in accordance with the market volatility levels predicted for the period, and for the duration of a trade.
Keep in mind that a ‘stop-loss to low’ could liquidate what could have otherwise been a profitable position. At the same time, a ‘take-profit to high’ might not be reached due to a lack of volatility. Paying attention to risk/reward ratios is also an important part of good risk management.
What is the Risk Return Ratio?
The Risk/Reward Ratio (or Risk Return Ratio/ RR) is simply a set measurement to help traders plan how much profit will be made should a trade progress as anticipated, or how much will be lost in case it doesn’t. Consider this example. If your ‘take-profit’ is set at 100 pips and your stop-loss is at 50 pips, the risk/reward ratio is 2:1. This also means that you will break-even at least every one out of three trades, providing that they are profitable. Traders should always check these two variables in tandem to ensure they fit with profit goals.
The best way to avoid risks completely in Forex trading is to use a risk-free demo trading account. With a demo account you can trade without putting your capital at risk, while still using the latest real-time trading information and analysis. It’s the best place for traders to learn how to trade, and for advanced traders to practice their new strategies. To open your FREE demo trading account, click the banner below!
Not Having or Not Following a Trading Plan
How else do Forex traders lose money? Well, a poor attitude and a failure to prepare for current market conditions certainly plays a part. It’s highly recommended to treat financial trading as a form of business, simply because it is. Any serious business project needs a business plan. Similarly, a serious trader needs to invest time and effort into developing a thorough trading strategy. As a bare minimum, a trading plan needs to consider optimum entry and exit points for trades, risk/reward ratios, along with money management rules.
There are two kinds of traders that come to the Forex market. The first are renegades from the stock market and other financial markets. They move to Forex in search of better trading conditions, or just to diversify their investments. The second are first-time retail traders that have never traded in any financial markets before. Quite understandably, the first group tends to experience far more success in Forex trading because of their past experiences.
They know the answers to the questions posed by novices, such as ‘why do Forex traders fail?’ and ‘why do all traders fail?’. Experienced traders usually have realistic expectations when it comes to profits. This mindset means that they refrain from chasing the price and bending the trading rules of their particular strategy – both of which are rarely advantageous. Having realistic expectations also relieves some of the psychological pressure that comes with trading. Some inexperienced traders can get lost in their emotions during a losing trade, which leads to a spiral of poor decisions.
It’s important for first-time traders to remember that Forex is not a means to get rich quickly. As with any business or professional career, there will be good periods, and there will be bad periods, along with risk and loss. By minimising the market exposure per trade, a trader can have peace of mind that one losing trade should not compromise their overall performance over the long-term.
Make sure to understand that patience and consistency are your best allies. Traders don’t need to make a small fortune with one or two big trades. This simply reinforces bad trading habits, and can lead to substantial losses over time. Achieving positive compound results with smaller trades over many months and years is the best option.
There we have it, the main reasons why Forex traders fail and lose money, along with the steps traders need to take in order to prevent them from occurring. Studying hard, researching and adapting to the markets, preparing thorough trading plans, and, ultimately, managing capital correctly can lead to profitability. Follow these steps and your chances for consistent success in trading will improve dramatically!
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About Admiral Markets
Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world’s most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
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Kevin Muir, longtime trader and market strategist at Toronto-based East West Investment Management, says he’s preparing for a market storm that nobody else seems to even be considering.
“Contrary to the debt-will-overwhelm-us crowd, I believe the next great financial crisis will not be a deflationary shock, but a return of inflation no one is positioned for,” he wrote in his Macro Tourist blog this week. “Don’t assume I am a hyper-inflationary doomsayer though. At first the inflation will feel great. It’s not until much later will it actually cause any real problems for the economy.”
In that kind of climate, Muir says a return of inflation is the best long-term risk-reward trade out there. “Hands down,” he said. “No other trade even comes close to offering this payoff asymmetry.”
His play: Get long inflation breakevens.
“Although many investors understand that TIPS (Treasury Inflation Protected Securities) are designed to offer an investor a way to insulate their bond against inflation, less recognize these securities offer a way to bet on inflation,” Muir explained in a blog post. “Inflation breakevens are simply the level of inflation the TIPS market is pricing in over the life of the bond.”
“ ‘It’s what market participants are least prepared for, and what will hurt the most.’ ”
He added that if we know the TIPS yield and also the yield on a regular nominal bond of similar maturity, we can calculate the market’s expectation for inflation — the inflation breakeven rate. “It’s nothing more than the difference in yield between the two different types of bonds,” Muir said.
So what’s the play? This is where it gets pretty wonky.
In his words, it’s as simple as getting long TIPS and short the regular bond. “If inflation ends up being more than the inflation breakeven rate,” he said, “then the trade would be profitable. If it ends up being less, it would result in a loss.”
That might be more than the average investor wants to take on. “Whoa!” Muir said, imagining the response. “I don’t want that sort of hassle.”
Here’s the simpler, ETF way to get long breakevens for those who want to stay out of the fixed-income weeds and still profit from spiking inflation: Go long the iShares TIPS Bond ETF TIP, -0.06% and short the iShares 7-10 Year Treasury Bond ETF IEF, -0.45% in equal dollars.
“What ‘everyone knows for sure but just ain’t so’ is the belief that inflation won’t (and can’t) return,” Muir said. “It’s what market participants are least prepared for, and what will hurt the most.”
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He predicts that sometime in the next decade that TIPS will see a surge in demand as investors desperately try to hedge themselves, which makes long inflation breakevens a core holding for Muir and one of the few assets he welcomes getting cheaper so he can build his position at better prices.
“Maybe my confidence is misplaced. Maybe all these deflationists are correct that governments are powerless to hit their inflation targets,” he wrote. “However, I’m willing to take the other side of that trade. I think governments will figure out how to create inflation. when they do, it’ll be too late to buy your insurance.”
Stocks were holding up nicely on Thursday, with the Dow DJIA, +7.73% , S&P SPX, +7.03% and Nasdaq COMP, +7.32% all logging gains.
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