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What happens if the stock doesn’t move? If the stock doesn’t move slowly, day by day, this option that you purchased would slowly erode in value. The reason is that you have the right, as a call buyer, to purchase the stock at the strike price that you purchased – in this case, $27.50 – at any time before the third Friday of May.
As we get closer to the third Friday of May, the chances of that stock moving up, beyond this strike price of $27.50, becomes less and less certain. Because of that, the option has less value to it.
If the probabilities are less that the stock will actually move above $27.50, then obviously, the value of holding that position, that contract, becomes decreasingly less expensive.
So, if you take a look at an option like this, over time – let’s say that the stock doesn’t really move. If, over time, like a week from now, maybe this option will be selling for 20 cent bid, 35 cent ask. A week after that, it’s 15 cents, and 25 cents. The week after that, maybe it’s 5 cents, and 10 cents.
Eventually, the option that you purchased for 40 cents, at the great hope that the stock was going to move up, is now only worth about 10 cents. You’ve lost 30 cents on the trade.
That’s exactly what the person who sold it to you was hoping would happen. That, in fact, the stock did not go up in price. You purchased this option that they know is going to expire, and will eventually erode in value, over time. That’s how they make their profit. They sold it to you at 40 cents. They can buy it back at 10 cents, making a 30-cent profit on that trade.
What about the guy who purchased the put option – the option that gives him the right to sell the stock at $27.50, hoping that it would go down, so he could buy it back at $22.50? If he could buy it at $22.50, and sell it at $27.50, he’s made a $5 profit.
That’s what his hope is. If the stock doesn’t do anything at all, the same exact thing is going to happen to his put option. Eventually, over time, because the actual probability that the stock is going to decline in price decreases, as these options get closer to expiration, on the third Friday in May, for our example here. Then, eventually, this option will be worth less and less each week.
Let’s say next week, at this time, if the stock does not move, then this option will be worth only 45 cents to 65 cents. Another week passes by. Now it’s worth only 35 cents to 45 cents. Now, another week passes by, and it’s only worth 25 cents.
As long as the stock does not move, all of these options will continue to decline in price, if they have an extrinsic value. If the prices of the options – these are called the “in the money” options. “In the money” options have some component of extrinsic value, and some component of intrinsic value.
The way you can determine extrinsic and intrinsic value is simply by taking the strike price of the option – in this case, we’re taking a look at the May 20 calls, and their price at $7.40. On these 20 calls, if you add the strike price to the price of the call, you get $27.40.
At the mid-price, you’re probably talking about $27.25, or $7.25, for the price of this call option. Which is exactly the price of the current stock.
You could say that this call option has no intrinsic value. In fact, if you look under extrinsic value, you can see the closer you get to the “at the money,” or the actual strike price of the stock, you can see that there is, in fact, some extrinsic value. There is some time value left in that option.
That time value is basically saying that, “Hey, you know what? We do have three or four weeks before expiration, so the price of the option may actually increase, to the point where it may actually be further ‘in the money.'”
What is our objective, though? You should already have a basic understanding of options. I probably haven’t told you anything new. Or maybe I have, I don’t know. But, depending on your experience – the important thing to remember, though, is that when we trade for monthly income, what we hope to do is not only sell options, we are going to sell both sides. We are going to sell calls, and we are going to sell puts.
The reason for that is because the stock cannot be at two places in one time. In other words, if you sell this $27.50, and you sell these 25s, it can’t be both at 25 and $27.50, at expiration. We’ve got to make money on one side, or the other.
That’s an important distinction to make, because we make money whether the stock goes up or down. Now, the types of vehicles that we use in order to trade options on the exchanges, are normally going to be – and I’ll go through all of those with you, in the next series here, in portfolio building – what we’re going to be using are called calendar spreads, and the sale of vertical spreads. Specifically, double calendar spreads, and the sale of iron condors.
Those two strategies will comprise most of our system, and most of the trades for the month, so we can make a monthly income. Let me just show you the trades that we currently have on, so you can get a picture of what I’m talking about.
These are trades that we’ve just put on recently. We have four positions. We have an iron condor, sale of an iron condor, in the Diamonds, which is a ETF that mimics the Dow Jones industrial average. We have a double calendar on the EEM, which is the emerging markets’ ETF. We have a double calendar position on the IWM, which is the Russell 2000 Index. ETF for the Russell 2000 index. And we have the sale of an iron condor on the Spy, which is an ETF on the SMP 500.
These positions, normally when you put them on, all show a loss at the open. However, there are a couple of things that you really need to take a look at.
Number one: This white line here is what our current profit and loss position is. You can see that the current price, the live price, of our portfolio based on the SMP 500, or on the Spy ETF, is right here. In fact, it is in the center between our breakeven point. Our breakeven point on the low end is down here, at about 133. Our breakeven point on the upper end of the price chart is 143.65.
We’re directly, almost in the center of that. Since we just put this position on, we are in a position of a slight loss in our position. However, what we need to take a look at is what happens to a purchase as an option. We are selling that option. We are the seller. There are two rules of the market, as far as options go.
Number one: They will fluctuate in price. Number two: They will always expire. We take advantage of both of those absolute rules of the option market. That’s what makes this strategy so powerful.
Number one: It fluctuates in price. Well, as you can see, we have lots of room to move. Right now, we’re about in the center of this little tent. I explained what this white line is. That’s our current profit and loss position. We’re currently in the losing position.
However, the maximum profit on this position is represented by the green line. The green line is what happens to that option at expiration. As you can see, if you take a look at this, down here in this corner, if the options were to expire today, we would make a maximum of $1249 on this position. It’s $517.08, and we have $1252 in potential profit in this position, at expiration.
Today is 4/22, and we have a loss of $79, so far. If we hold this to expiration, these options slowly will decline in value, until they get close to the expiration date. That is the third Friday of May. That’s what this green line represents – the third Friday of May.
Eventually, this white line will continue to go up, and go up, and go up, until it meets this green line, in which we’ve achieved our maximum profit. That’s how monthly income is derived from the markets – by selling options to people who want to buy them, who are taking bets on the stock, whether it’s going to go up or down.
It doesn’t matter to us. It doesn’t matter if the stock goes up or the stock goes down. We make money both ways. Our maximum actual profit position will change, depending on the price of the stock itself. We may have a little bit more profit, or may have a little bit less profit, but we take advantage of one of the major, undeniable rule of options, which is that they will fluctuate in price.
Number two: We take advantage of the second rule of option trading. That is, that all option contracts expire. Once they expire, they either become worthless, or if they have intrinsic value, if they’re “in the money,” they do have some value left to them. We take advantage of those options that are generally “out of the money,” that have a low probability of actually being worth anything at all, and capturing that, so we can make money.
Does this work out all of the time? It does, and it doesn’t. The reason I say that is because prices do fluctuate. For example, if you put this trade on, and all of a sudden, prices ran up very, very high, and very close to your breakeven point, what would you do?
You’d be in a losing position. Also, if you were far from expiration, or if you were close to expiration, then you might show a small profit here. The real key to making this system work is adjustments.