In the first part of my series on "trading with the odds," I explained credit spreads and other options basics. I used a November $40/$42.50 credit spread on eBay (Nasdaq: EBAY ) to show that, since options markets are efficient, the net credit you receive from selling that spread is a fair price. I also explained that selling the spread had a 60% chance of being profitable. In part two, I'll explain how selling time decay makes you money most of the time.
The beauty of decay
The fairness of options pricing doesn't guarantee you a profit. After all, the expected profit of a fairly valued options trade is zero at the moment the trade is initiated! (If the expected value were positive, nobody would be willing to sell the option. If it were negative, nobody would be willing to buy.)
This is where things get interesting. Options have a unique feature called time decay. Since options are, in essence, a bet on the future price movement of a stock, time is a prime component of an option's extrinsic value. The less time remaining until expiration, the less value an "out-of-the-money" call option (an option whose strike price is above the current stock price) has, because it becomes less likely that the stock will rise enough to let the option expire "in the money." With each passing day, the time value of an option inexorably declines.
What does time decay mean for our eBay spread? Assuming that the stock price doesn't change, time decay ensures that the spread's expected profit doesn't stay at zero. Time works in the position's favor. As each day passes, the probability that eBay remains under $41 at its November expiration increases, thereby pushing the spread's expected profit more and more above the zero line.
Options analysis software can help you calculate that this probability increases from about 60% today to 64% next month. This puts the fair-value price of the spread somewhere around 90 cents.
Assuming everything else remains constant, in one month's time the expected profit of your spread has moved from zero to $0.10 ($1.00-$0.90) per contract. Because the options market is efficient, it's highly likely that you could buy back the spread (i.e., buy to close the $40 call and sell to close the $42.50 call) at 90 cents and pocket the ten cents as profit.
Doesn't sound like much, but on an initial risk of $1.50, a $0.10 return amounts to 6.7% -- pretty good compared to the casino's 5.26% edge in roulette. Especially since that edge continues to grow larger with every passing day that eBay's stock price stays around the same level.
Just as time decay works for the options seller, it works against the options buyer. Thus, after one month, with nothing else changing, an option buyer is 6.7% in the hole and still sinking. That makes options buyers a lot like casino gamblers - sure to lose over the long run.
It's also why professional options market makers are almost always short options rather than long. According to Tom Sosnoff, founder and CEO of the Chicago-based thinkorswim brokerage, as well as a former Chicago Board Options Exchange market maker, "The majority of professional traders I know aren't net long option premium on a regular basis. The odds are against you. I think survival depends upon collecting time decay."
Of course, it's possible that the day after you sell the eBay call spread, the stock will skyrocket. It's not likely -- most of the time, stock prices remain within a narrow range -- but it could happen. If it does, your sale of the call spread could result in a big loss.
Remember, however, that if a stock makes a big move in the wrong direction, it won't necessarily stay there. It could easily make a round trip by its November expiration and return to a profitable price point. Alternatively, eBay shares could suddenly plummet, which would help the profitability of the credit spread.
In fact, selling time decay is a high-probability trade precisely because an options seller has two chances to win and only one chance to lose. In our eBay example, the seller of the $40 call wins if eBay's stock price stays the same or falls. She loses only if the stock price goes up significantly. The buyer of the $40 call wins only if the stock price significantly rises.
Cover your assets
Despite winning in two out of three scenarios, options sellers still risk losses. I recommend that you never sell an option without buying another one as insurance. Simply selling the $40 call would earn you $2.20, improving the breakeven price of your trade to $42.20. For the single short call, that may sound better (and more profitable) than my spread's breakeven price of $41. But selling the $40 call by itself has unlimited risk.
If eBay shoots up to $100 from the current price of about $39, the seller of a $40 call would need to pay $60 to close out her position, a net loss of $57.80 ($60-$2.20) per contract. Such a huge loss could wipe you out, preventing you from the benefit of having the odds in your favor over the long run.
In contrast, the maximum loss of my call spread is fixed at $1.50 per contract, regardless of how high eBay climbs. My $42.50 call will be worth $57.50 if eBay hits $100, yielding me a net profit of $56.30 ($57.50-$1.20), which offsets all but $1.50 of the $57.80 loss on my short $40 call. Limiting my risk keeps me in the game until the long-term odds start working in my favor. That's what I call peace of mind.
Collecting time decay can be done in many ways, with any view of market direction. Besides selling a call spread above the stock's current price, which implies a bearish market view, you could sell a put spread below the stock's current price, which implies a bullish market view. Or you could sell both a call spread above and a put spread below, which implies a neutral market view. Or you could sell a near-term put or call in November and buy a farther-out put or call in December. The possibilities are virtually endless.
The house (almost) always wins
Does this mean you'll profit every time? Of course not, even if the odds are in your favor. A 60% chance of profit still means you'll lose 40% of the time. Casinos understand that the house edge only applies over tens of thousands of roulette-wheel spins. That's why casinos, despite their house edge, limit how much a gambler can bet on any one spin. They don't want to be bankrupted by a gambler's single, gigantic lucky bet.
Options traders need to adopt casinos' mindset. You should limit the amount of capital risked on any single option position (2.5% of your capital is a good rule of thumb), then sell option spreads (i.e., time value) in an endless series of small trades to capitalize on the small long-term edge options sellers get from time decay.
Don't limit yourself to a single eBay spread. Supplement it with spreads on Microsoft (Nasdaq: MSFT ) , Time Warner (NYSE: TWX ) , Google (Nasdaq: GOOG ) , and Pfizer (NYSE: PFE ) , for example. You should diversify not only among stocks, but also over time -- perhaps by investing a third of your capital each in November, December, and January spreads.
Of course, it's still possible that you could lose on your option trades 40 times in a row and get wiped out. That scenario's unlikely, though; a 60% probability means that you'll win more than you lose over the long term. Taking advantage of time decay is not a get-rich-quick scheme, but it does seem to work. Why should Las Vegas casinos have all the fun?
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Fool financial editorJim Finkspent many years losing gobs of money buying options and watching his money disappear with time decay. Now he makes a little money selling options and having time decay work in his favor. May the odds be with you. He has no financial interest in any of the companies mentioned but does hold a brokerage account with thinkorswim, Inc. Data provided by thinkorswim. The Motley Fool has an ironclad disclosure policy.