Time is the enemy of the options buyer
Trading options can be complicated, as there are a lot of moving pieces. It's important to stick to a core set of principles when approaching any options trade. Here at Schaeffer's, we have a simple mantra for vetting stocks before buying an option:
F.A.R., or
Fast,
Aggressive, and in the
Right direction. That is how you need a stock to move in order to profit on a short-term call or put purchase. Below, we will unpack this mantra, and outline what metrics are used to judge it.
A Stock Must Move Fast Due to an Option Trade's Finite Life
The reasons why you want a stock to move fast is because of two factors. First, the expiration date of an option shortens your timeline to profit. In other words, you have a narrower window of opportunity compared to a stock buyer. If you think a stock will slowly move up or down the charts, a short-term options play may not allow you to fully capitalize on the momentum (or lack thereof).
Second, because time is the enemy of the option buyer, the value of his/her option position will deteriorate with each passing day by an increasing amount, absent a significant price move in the preferred direction. To combat time decay, the option buyer wants the underlying security to move Fast.
A Stock Must Move Aggressively for the Option Buyer to Profit
The reason why you want the underlying stock to move aggressively is due to the setup of an option trade. In order to exceed the breakeven price on an option purchase, you need the stock's move to be of such magnitude that it at least covers your initial premium paid. Indicators such as the
Schaeffer's Volatility Scorecard (SVS) make it easier to compare stocks that tend to make outsized moves on the charts, relative to what the options market has priced in.
A Stock Must Move in the Right Direction -- But Not Always
The reason why you want a stock to move in the Right direction is fairly obvious. If you expect the stock to go up and it goes down, you lose money on your call purchase. However, one great thing about options trading is the ability to profit in really any situation. For example, the
long straddle and
long strangle essentially eliminates direction from the equation. A trader can then focus on customizing the timing and magnitude of their options trade.
Even If the Stock Doesn't Move F.A.R., Risk Is Limited
In conclusion, the finite life of an option contract means that options traders must time the underlying stock's expected move precisely, and hope the shares move Fast enough before options expiration. Even more, they need the equity to move Aggressively enough to make money on their options trade, and obviously in the Right direction. But, even if the option buyer is wrong, the most he or she can lose on the trade is the initial premium paid for the contract, so unlike a stock buyer, risk is limited. For a deeper dive on this subject, check out
tips for short-term options trading, or
how to trade weekly options.