With options, time matters

One potentially overlooked early highlight of this week’s trading was the appearance of First American Financial (FAF) at the top of the LiveAction scan for highest call-put ratios on Monday morning:

In the first 15 minutes of trading, the specialty insurance company’s call volume was 1,575 times its put volume. True, FAF’s position at the top of the list was due to the fact that only one put had traded, but the call activity was still notable for this modestly traded stock.

FAF’s options chain showed the volume in question occurred in the February $70 calls expiring on Friday. Not surprisingly, with the stock trading more than $6 below this strike price, the options traded for just $0.02:

The fact that the contract’s open interest (OI) was the same as the volume suggests this may have been a case of a large trader getting out of an existing position. And in fact, digging a little deeper revealed that, before Monday, this option had traded on just two dates, January 17 and January 31.

While the volume on January 31 was 75 contracts, the volume on January 17 (1,562) was nearly identical to Monday’s volume (1,575), which means there was a good chance the position was opened on January 17 when the call was trading at $0.40. In a nutshell, that means a trader who bought the option on January 17 and sold it Monday lost 0.38 ($38) per contract, while a trader who shorted it on January 17 realized a $38 per-contract profit—a profit or loss of $59,356 on 1,562 contracts.

What may surprise some observers is that a trader who bought the calls on January 17 would have been on the losing side of the trade, even though on Monday FAF opened 2.8% above its January 17 close:

All else being equal, a rising stock price should be accompanied by rising call prices. In this case, though, all else was not equal. First, FAF released earnings after the bell last Wednesday. Options implied volatility (IV) typically rises in the run-up to an earnings release and declines after it, since the uncertainty surrounding the numbers has been removed. High or rising IV tends to inflate options premiums, while low or falling IV has the opposite effect.

Second, and probably more importantly in this case, all options lose value over time, and that “time decay” accelerates as expiration approaches.

FAF closed at $61.97 on January 17, which means the February $70 call had no “intrinsic value” (a positive difference between the stock price and the call price). Instead, the call’s $0.40 premium consisted entirely of “extrinsic value”—that is, time value and IV. Since both declined, the option’s premium fell almost to zero by Monday, even though the stock had climbed nearly 3%.

With options, success or failure sometimes isn’t so much about the direction of the underlying stock price as it the direction of volatility and the passing of time.

Market Mover Update: While many traders and investors have been focused on the potential impact of tariffs, in “Trump 2.0 and the Potential Economic Impact of Immigration Policy,” Morgan Stanley & Co. analysts shed light on another area of policy that could impact the markets.

Today’s numbers include (all times ET): mortgage applications (7 a.m.), housing starts and building permits (8:30 a.m.), Atlanta Fed business inflation expectations (10 a.m.), FOMC minutes (2 p.m.).

Today’s earnings include: Analog Devices (ADI), Fiverr (FVRR), Carvana (CVNA), Exact Sciences (EXAS), EQT (EQT).

Click here to log on to your account or learn more about E*TRADE's trading platforms, or follow the Company on Twitter, @ETRADE, for useful trading and investing insights.