Keeping track of time (value)

Options are multi-faceted tools that can play a role in a wide range of trading and investing strategies, but as the following example will show, traders who don’t keep tabs on a few basic principles can find themselves with surprising—and unwelcome—results.

For example, HealthEquity’s (HQY) strong rally off its mid-December lows began to lose momentum toward the end of February. On February 22, the stock closed at $82.26. Eleven weeks later, on May 9, it closed at $77.45:

Given this decline, one would reasonably expect a trader who bought the $80 put option on February 22 to have been sitting on a profit on May 9. After all, the option went from being more than $2 out of the money (OTM) to more than $2 in the money (ITM).

No such luck. The option closed at 5.30 on February 22 and 4.80 on May 9—a net decline, even though the stock fell 5.9% during this period:

A few factors may have contributed to this outcome, but two are especially important. First, HQY’s implied volatility (IV) gradually declined during this period, from 39.30 on February 22 to 33.30 on May 9. All else being equal, high/rising IV tends to inflate options premiums, while low/falling IV can have the opposite effect.

Second, all long options lose value as time passes, and this “time decay” accelerates as expiration approaches. We can find out how much time value an option has lost by subtracting its “intrinsic value”—the difference between an ITM option’s strike price and the current stock price—from its premium.

Because the $80 put was OTM (below the stock price) on February 22, it didn’t have any intrinsic value. That means its 5.30 closing price on that day consisted entirely of time value and volatility—also referred to as an option’s “extrinsic value.” On May 9, the put’s intrinsic value was 2.55 ($80–$77.45), which means the remaining 2.25 of its 4.80 closing price was extrinsic value (time value/volatility). In other words, the put’s extrinsic value had fallen nearly 50% since February 22.

The next two charts show the same dynamic playing out on the call side of the equation. From May 15-June 10, HQY rallied from $75.85 to $86.94:

Meanwhile, the June $80 call rallied from 2.10 to 7.09 between those two dates:

While this may appear to be an example of “how things should work”—a stock rallied, and so did its call options—time took a toll on this position, too.

Because the $80 call was OTM (above the stock price) on May 15, it had no intrinsic value—which means its premium on that date (2.10) was entirely extrinsic. On June 10, the call’s intrinsic value was 6.94, which means its extrinsic value was only 0.15 (7.09–6.94). That translates into a nearly 93% loss of time/volatility value in less than four weeks.

Traders who buy options need to make sure they have factored in their one unavoidable downside—the loss of value over time. Some traders may simply choose to limit the duration of their trades. Others may construct multi-leg positions (spreads) that incorporate short options. A common example is a “vertical” spread—such as the bull call spread, which typically combines a long ATM call with a short, higher-strike call. The short call benefits from time decay, thus offsetting at least some of the long call’s loss of time value. The other side of the coin is that this strategy surrenders the theoretically unlimited upside of an outright long call position.

Depending on the situation, a trader may find that compromise acceptable. There are no perfect solutions in the markets, only trade-offs between risks and potential rewards.

Today’s numbers include (all times ET): mortgage rates and applications (7 a.m.), Housing Starts and Building Permits (8:30 a.m.), Q1 current account (8:30 a.m.), weekly jobless claims (8:30 a.m.).

Today’s earnings include: Jabil (JBL), Signet Jewelers (SIG), Adobe (ADBE), RH (RH).

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