Strategies to mitigate loss of time value in an option
Let us first understand what do we mean by time value of an option and how it affects the option prices and then understand how an investor/ trader can manage it to minimize its impact.
Time value of an option:
One of the major components of an option price is the time value. In simple terms, it is the probable payoff of the option over the time to expiry of the option.
The time value increases with higher volatility and higher time to expiry. Thus any option buyer needs to pay this time value as a cost for the protection/ expression of view. Higher the implied volatility or the time to expiry, higher is the time value/ premium that the option buyer needs to pay.
Risks for an option buyer:
As can be clearly seen, the time value is an expensive component and hence an option buyer always loses value as and when more time elapses or the implied volatility reduces.
It is very difficult to time the market which effectively means that the option buyer will lose money if either of the following things happen:
a. More time is elapsed without the view getting correct
b. View getting incorrect
c. Reduction in volatility which effectively reduces the size of the payoff.
Risks for an option seller:
So buying an option as can be seen is fraught with a lot of risks as mentioned above. On the other hand, selling an option would be profitable as the seller would benefit from either of the above 3 things happening. However selling an option exposes the seller to the following risks:
a. Unlimited downside and limited upside (only the option premium)
b. Increased implied volatility
c. Much higher margins as there is unlimited downside
So as can be seen, there are risks involved on both sides and its sometimes difficult to determine which side would an investor like to be based on the above. Over a period of observations and analysis, I have come up with the following strategy which helps in reducing the impacts for most of the above risks.
Strategy
In this strategy, the investor basically buys 1 lot and then sells 2 lots each at higher prices. To make things easier to understand, lets take a view that the stock price is 90 and the investor believes that it will cross 100.
As per the above strategy, the investor will buy 1 lot of 95 Call and sell 1 lot of 110 Call and 1 lot of 120 Call (Note: the investor can adjust the buy and sell prices based on his conviction and the risk rewards – the important things to keep in mind is that the closer the call is to the strike, higher will be the buy premium; also the further are the sell calls – lesser will be the received premium – but also there will be much higher gains if the calls go right ; Also note that the last written call should be at a price which investor thinks has a very low probability of getting executed as he will lose money once the price crosses that threshold – so ideally it should be a resistance)
Benefits of the above strategy:
The benefits of the above strategy are:
a. Negligible time value loss, in fact the investor has sold 2 options and hence may have very minimal theta and in some cases can even be a gain on time value.
b. Lesser impact of reduction in Implied volatility as 2 options are sold. Also, increase in implied volatility may not impact the investor much as the vega peaks at the money (please read my article on option vega for more details).
c. Minimal loss if view is incorrect as the sold option premiums compensate for bought option premium loss
The major risks are :
a. If the stock prices rallies beyond the second sold option, then the investor will start losing money and can have unlimited downside; hence the second sold option should be at a very strong resistance/ prices which are far away so that the downside is protected.
In conclusion, I recommend taking these trades more on the call side as compared to put sides as market rallies are generally not very severe as compared to downsides (where there is unlimited downside risk). Also, this will help investor conserve capital when views go wrong as well.
