Volatility Is an Option Trader’s Double-Edged Sword

I made a bad call a couple weeks ago.

I suggested buying calls on Virgin Galactic (NYSE: SPCE), Richard Branson’s space company.

It looked like the stock was going to retest its three-month high.

It didn’t…

A couple days after I made this call, the stock cratered. It’s down over 40% since.

While that wasn’t my best call, this is actually what makes SPCE one of my favorite stocks to trade.

It’s just so stinking volatile — and volatility is an options trader’s best friend.

I mean … just look at this volatility! It’s practically delicious.

(Click here to view larger image.)

Up 513%, down 80%…

Up 180%, down 62%…

Up 312%, down 50%…

All in the span of just over a year.

I love trading stocks like this because they move so much, and it’s relatively easy to time their tops and bottoms. I’ve made quite a bit of money trading SPCE doing just this.

But volatility can be a double-edged sword for options traders…

In fact, I’m catching the wrong edge of this sword right now … and it hurts.

So today I want to show you what went wrong, and how you can prevent it from happening to you.

It’s something you need to understand if you’re ever going to trade options successfully.

Race Against Time

The “wrong edge” I’m talking about is time decay.

See, all options expire at a certain date. As you get closer to that date, the option can lose value rapidly. It’s a race against time.

You probably know the key thing of trading options is getting the direction right. If you’re confident that a stock will move in a certain direction, you can trade options to apply leverage and boost your returns.

But you have to get the timing right as well. You need to decide whether the stock will hit your target price next week, next month, three months from now, six months from now … etc.

This is because time decay gets VERY tricky the closer you get to an option’s expiration. The time decay accelerates especially in the last 30 days.

If you buy an option that expires six months from now and the underlying stock doesn’t move that day, the option might fall just a smidgen, if at all.

But if you buy an option that expires this Friday and the stock doesn’t move, your “premium” (the amount you paid for the option) will deteriorate fast.

And it gets trickier…

How Volatility Accelerates Time Decay

Even if you get the direction right on a short-term option, the move has to be substantial enough to offset the time decay.

Let’s go back to SPCE.

As you might imagine, after the stock has fallen 40% in two weeks, I’m eyeing a short-term rebound. I wanted to trade that potential rebound this week.

So on Monday, I bought the SPCE $32 July 23 call option for about $2.33, hoping to profit from the short-term rebound. Factoring in the $2.33 premium, I would need SPCE to trade above $34.33 for the option to have intrinsic value.

I bought the calls toward SPCE’s low in the trading day, at around $30 per share.

From there, it inched a little higher. Since the stock went the direction I was predicting, you might think my options should have made money.

Instead, they slipped by about 20%.

This is because, with volatility high, options premiums are very expensive right now…

As Mike Carr showed you yesterday, when institutional traders are bearish and bidding up put options on S&P 500 futures, that actually raises volatility.

Plus, a lot of new money has entered the market over the last year. A lot of that new money is trading options, which contributes to this high volatility.

To top it off, bearish sentiment is very high compared to last week’s sell-off (see below for our “Chart of the Day”)… When traders are bearish and buying put options, this also tends to raise options premiums quite a bit.

With all these factors, the time decay effect is going to be more severe than normal.

Of course, this option could still wind up profitable by Friday if it goes into the money. But unless that happens, time decay is going to decimate the option’s value.

What You Should Take Away From This

Direction … time decay … premiums … oh my!

It’s a lot to learn for a new trader.

This is why we publish True Options Masters. Because there are so many variables to consider and it helps to have real experts to guide you.

When you trade short-term options, expiring in less than a month, you need to anticipate a VERY big, short-term move in the underlying stock or exchange-traded fund (ETF) if you want to make money.

For instance…

On Monday, I sold some Invesco QQQ Trust (NASDAQ: QQQ) puts I had recently bought, and made some good money from yesterday’s sell-off.

QQQ is the main ETF that tracks the Nasdaq 100 technology index.

Tuesday morning, I anticipated a short-term rebound. So I bought some QQQ calls before 10 a.m.

I had until the end of the week before these calls would expire. But I didn’t wait that long.

In that two-hour window, QQQ rose 1% — a big move for an index ETF. By 11:45 a.m., I sold those calls for a 60% gain.

I’m almost certain I could’ve held on for bigger gains, but why bother?

I got the direction right… I knew time decay would eat away at the premium the closer I held to Friday… And I knew options premiums are expensive right now, which would only accelerate the time decay.

The more I grow as an options trader, I try not to look a gift horse in the mouth. When I trade short-term options, I’m quick to take my gains.

When you trade short-term, you should do the same.

Stay tuned for tomorrow’s Bank It or Tank It series with Chad Shoop…

Ciao,