Section Title

HOW TO BUY OPTIONS WITHOUT THE FEAROF GETTING CRUSHED IN TIME DECAY ANDVOLATILITY

By Joshua Belangerwww.OptionSIZZLE.com

The risk of loss trading futures, options, currencies and other leveragedtransaction products can be substantial. Therefore only "risk capital" should beused. Futures, options, cash currencies and other leveraged transactionproducts are not suitable investments for everyone. The valuation of futures,options, cash currences and other leveraged transaction products mayfluctuate and as a result you may lose more than the amount originallyinvested and may also have to pay more later. Consider your financialcondition before deciding to invest or trade. All examples are hypothetical andshould be used for educational purposes only. Although every attempt hasbeen made to assure accuracy, we do not give any express or implied warrantyto accuracy. We do not accept any liability for error or omission. Examples areprovided for illustrative purposes only and should not be construed asinvestment or trading advice.

Open 4,160.03 High 4,160.96 Low 4,131.79

For those inattendance, how manyof you trade equityoptions?

For those whoanswered yes, howmany of you are justbuying basic puts orcalls for directionalplays?

How many of you feel that you're having thisproblem when buying option premium?

-Not buying the right strike price

-Buying too much time

-Not buying enough time

The stock moves in thedirection youanticipated...but you stillend up losing money

Does that soundfamiliar?

What if I told you that we could fix that.That every time you were right on yourdirectional opinion... you'd end upmaking money on virtually every trade.

I'm not joking...It's not a magic or a secretstrategy...It boils down to understanding howoptions work.

Joshua Belanger, Founder of OptionSIZZLE

-Started my career as a runner on the Chicago Mercantile Exchange-Moved on to work at premier brokerage firms and trading desks-Managed money privately for clients-Founded OptionSIZZLE in 2008.

Was one of the first people on the web highlighting unusual options activity. Which caught the eye ofBloomberg, BusinessWeek, the New York Post, Reuters, Dow Jones Newswire, Yahoo Finance andthe Wall Street Journal.

Before we get into it...it's important werun down some key terms and the basics.

When you're buying an option, you arenot just trading direction.

You can still end up losing money ifyou buy calls when the stock pricerises (or lose money from buying putsif the stock price drops)

The movement of the stock price is justONE component of how options are priced.

You also have to take into account theoption strike price selected, the time toexpiration and the implied volatility.

When it's all said and done, the optionpricing model is simply a probability model.

Whenever You buy an option you are also long

option volatility (AKA implied volatility)

In addition, time decay is working against you.

The reason why most traders lose money on longoptions (if they got the direction right) is that theyeither got the timing wrong, misjudged theimplied volatility or even both.

An option is composed of intrinsic value and extrinsicvalue.

At expiration...All options finish in the money or expireworthless.

Intrinsic value is what the option would be worth if todaywas hypothetically expiration.

Extrinsic value is the time value and volatility component(the probability element of options).

Facebook on April 1, 2014 closed at $62.62 We are looking at options that expire on 4/4/14

The $61 calls (ITM) were priced at $2.01Intrinsic Value of $1.62 and Extrinsic Value of $0.39

The $62.50 (ATM) were priced at $1.04Intrinsic Value of $0.12 and Extrinsic Value of $0.92

In this example, the options were 3 days from expiration, notice how quickly the extrinsic value willget sucked out of the $62.50 calls if the stock price sticks around that price.

Only ITM options haveintrinsic value.

ATM and OTM options onlyhave extrinsic value.

At expiration we are left withthe intrinsic value

The deeper ITM an option is...the more it will move along with the stock price

The stock moved from $60 to $61 from the following day. The option price of the callwent from $10.15 to $11.10

ATM and OTM options also move along with the stock...but implied volatility and timedecay play a much bigger role.

The stock moved from $60 to $61 from the following day. The option price of the callwent from $1.03 to $1.27

You might be thinking that's pretty good. However, we are assuming that volatilityremained constant (which it never does). What if it dropped five points instead?

The stock moved from $60 to $61 from the following day. The option price of the callwent from $1.03 to $0.97...when implied volatility dropped from 40% to 35%

When you trade ATM or OTM optionsthat are further out in time, you'remaking a bet that volatility stays level orincreases. In the last example, the stockprice moved in our favor, but the dropin volatility and time decay had a biggereffect.

Symbol Price Change Volume

$64 $215 $112 $22.4

Most directional traders focus on technical analysis and pricelevels...they aren't sophisticated enough to predict the direction ofimplied volatility.

With near term options, The wost enemy of ATM and OTM options when buying premium is TimeDecay (Theta)

With longer term options, The worst enemy of ATM and OTM options when buying premium isImplied Volatility (Vega)

Of course, Implied Volatility rising can also be your best friend...but then again, do you really have anopinion on volatility or are you hoping to get lucky.

Implied Volatility Factor

Volatility Factor

Often times implied volatility will get elevated ahead of an announcement...we see it withpending FDA releases and earnings. Basically, anything that causes uncertainty...which has thepotential to move the stock price big in either direction.

Once that uncertainty disappears...volatility gets crushed.

Implied Volatility can also get elevated from Supply & Demand factors. This can occur fromunusual options activity.

If you're going to be tradingoptions to make directionalbets, you want to reduce therole that time decay andimplied volatility play.

Facebook: Stock Price on April 1, 2014 was $62.62

Expiring in 3 Days

75 delta calls: $2.01 Intrinsic value: $1.62 Extrinsic value: $0.3953 delta calls: $1.04 Intrinsic value: $0.12 Extrinsic value: $0.9223 delta calls: $0.31 Intrinsic value: $0 Extrinsic value: $.31

Expiring in 31 Days

72 delta calls: $7.10 Intrinsic value: $5.12 Extrinsic value: $1.9850 delta calls: $3.93 Intrinsic value: $0 Extrinsic value: $3.9325 delta calls: $1.41 Intrinsic value: $0 Extrinsic value: $1.41

Expiring in 81 Days

75 delta calls: $10.08 Intrinsic value: $7.26 Extrinsic value: $2.8248 delta calls: $4.58 Intrinsic value: $0 Extrinsic value: $4.5823 delta calls: $1.68 Intrinsic value: $0 Extrinsic value: $1.68

Time Factor

As we've discussed, the biggest issuepremium buyers have is that they eithergetting the time or volatility factorwrong.

But there's ways around this...ways thatwill reduce the role of time decay andexposure to volatility.

First, buy options with high intrinsicvalue. For example, buy an option with adelta of 70-75. In many ways this couldbe viewed as a stock substitute with abuilt in stop.

The benefit of this approach is that thereisn't a whole lot of extrinsic value in theoption premium. In fact, If the stockdoesn't move much...you won't get killedin time decay.

What time frame should you select whenbuying options?

Well, this really depends on your opinionon where you think the stock will go andby when.

The beauty behind selecting deep ITMoptions is that we don't have to worryabout all that extrinsic value gettingsucked out of the premium.

I'll show you some live examples in alittle bit...

The second idea is to buy spreads. Also knownas vertical or debit spreads.

The beauty behind spreads is that they bringdown the cost and give you a better break-even point. The only downside is that yourprofit potential is capped.

By buying an ITM option and selling an ATM orOTM option against it, you are reducing theeffect of time decay and volatility.

It's another way to play for a directionalmove...without worrying about getting the timeand volatility aspect correct.

Facebook, options expiring in 31 days, stock price at$62.62 on April 1, 2014

72 delta calls: $57.50 strike, priced at $7.10

25 delta calls: $71 strike, priced at $1.41

What's the intrinsic and extrinsic value of theseoptions?

Facebook, options expiring in 31 days, stock price at $62.62 on April 1, 2014

72 delta calls: $57.50 strike, priced at $7.10

25 delta calls: $71 strike, priced at $1.41

If you bought the spread, it would cost $5.69, Inaddition, the intrinsic value would still be $5.12.However, your extrinsic value would decrease to $0.57compared to $1.98 if you just bought the call outright.Your break-even point has gotten better too. From$64.60 to $63.19. By selling the $71 call, we've reducedour exposure to time decay and implied volatility.

QUESTIONS?

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