Best of the Week
Most Popular
1. 2019 From A Fourth Turning Perspective - James_Quinn
2.Beware the Young Stocks Bear Market! - Zeal_LLC
3.Safe Havens are Surging. What this Means for Stocks 2019 - Troy_Bombardia
4.Most Popular Financial Markets Analysis of 2018 - Trump and BrExit Chaos Dominate - Nadeem_Walayat
5.January 2019 Financial Markets Analysis and Forecasts - Nadeem_Walayat
6.Silver Price Trend Analysis 2019 - Nadeem_Walayat
7.Why 90% of Traders Lose - Nadeem_Walayat
8.What to do With Your Money in a Stocks Bear Market - Stephen_McBride
9.Stock Market What to Expect in the First 3~5 Months of 2019 - Chris_Vermeulen
10.China, Global Economy has Tipped over: The Surging Dollar and the Rallying Yen - FXCOT
Last 7 days
After 8 Terrific Weeks for Stocks, What’s Next? - 16th Feb 19
My Favorite Real Estate Strategies: Rent to Live, Buy to Rent - 16th Feb 19
Schumer & Sanders Want One Thing: Your Money - 16th Feb 19
What Could Happen When the Stock Markets Correct Next - 16th Feb 19
Bitcoin Your Best Opportunity Outside of Stocks - 16th Feb 19
Olympus TG-5 Tough Camera Under SEA Water Test - 16th Feb 19
"Mi Amigo" Sheffield Bomber Crash Memorial Site Fly-past on 22nd February 2019 VR360 - 16th Feb 19
Plunging Inventories have Zinc Bulls Ready to Run - 15th Feb 19
Gold Stocks Mega Mergers Are Bad for Shareholders - 15th Feb 19
Retail Sales Crash! It’s 2008 All Over Again for Stock Market and Economy! - 15th Feb 19
Is Gold Market 2019 Like 2016? - 15th Feb 19
Virgin Media's Increasingly Unreliable Broadband Service - 15th Feb 19
2019 Starting to Shine But is it a Long Con for Stock Investors? - 15th Feb 19
Gold is on the Verge of a Bull-run and Here's Why - 15th Feb 19
Will Stock Market 2019 be like 1999? - 14th Feb 19
3 Charts That Scream “Don’t Buy Stocks” - 14th Feb 19
Capitalism Isn’t Bad, It’s Just Broken - 14th Feb 19
How To Find High-Yield Dividend Stocks That Are Safe - 14th Feb 19
Strategy Session - How This Stocks Bear Market Fits in With Markets of the Past - 14th Feb 19
Marijuana Stocks Ready for Another Massive Rally? - 14th Feb 19
Wage Day Advance And Why There is No Shame About It - 14th Feb 19
Will 2019 be the Year of the Big Breakout for Gold? - 13th Feb 19
Earth Overshoot Day Illustrates We are the Lemmings - 13th Feb 19
A Stock Market Rally With No Pullbacks. What’s Next for Stocks - 13th Feb 19
Where Is Gold’s Rally in Response to USD Weakness? - 13th Feb 19
US Tech Stock Sector Setting Up for A Momentum Breakout Move - 12th Feb 19
Key Support Levels for Gold Miners & Gold Juniors - 12th Feb 19
Socialist “Green New Deal” Points the Way to Hyperinflation - 12th Feb 19
Trump’s Quest to Undermine Multilateral Development Banks - 12th Feb 19
Sheffield B17 US Bomber Crash 75th Anniversary Fly-past on 22nd February 2019 Full Details - 12th Feb 19
The 2 Rules For Successful Trading - 12th Feb 19 -
Financial Sector Calls Gold ‘Shiny Poo.’ Are They Worried? - 11th Feb 19
Stocks Bouncing, but Will They Resume the Uptrend? - 11th Feb 19
EURO Crisis Set to Intensify: US Dollar Breakout Higher
Stock Market Correction Starting? - 10th Feb 19
Gold Stocks Gather Steam - 10th Feb 19
Are Gold Bulls Naively Optimistic? - 9th Feb 19
Gold, Silver Precious Metals Update - 9th Feb 19
The Wealthy Should Prepare to Be Soaked - 8th Feb 19
US Business Confidence Is Starting to Crack - 8th Feb 19
Top Myths and Facts about ULIP Plans - 8th Feb 19
A Major Stocks Bear Market in 2020? - 8th Feb 19
Gold Market Extremes Test Your Mettle - 8th Feb 19
The Venezuela Myth Keeping Us From Transforming Our Economy - 8th Feb 19

Market Oracle FREE Newsletter

The Real Secret for Successful Trading

The Anatomy of an XOM Earnings Options Trade

Companies / Options & Warrants Feb 07, 2013 - 10:16 AM GMT

By: J_W_Jones

Companies

One of the most interesting aspects of options is the myriad opportunities presented for high probability trades for those who understand the details of option behavior.

For example, I have recently discussed the routinely observed collapse of implied volatility immediately following an earnings release. We have looked at several examples of profitable trades constructed to benefit from this expected decline in implied volatility.


Today I would like to review another group of trades based on a fundamental characteristic of option pricing. In order to understand this phenomenon, we need to review briefly the anatomy of the price of an option.

Remember that an option’s price, while quoted as a pair of bid / ask values, is in reality the sum of two components. The current market price is the combination of the extrinsic and intrinsic components of the individual option contract.

The extrinsic component can comprise the entirety or only a variable portion of the market price of an option. All options contain at least a small amount of extrinsic component.

The intrinsic component of an option may comprise the majority of the value of an option, as for example a deep in-the-money option. Conversely, an individual out-of-the-money option routinely contains no intrinsic value whatsoever.

As an example, consider two current option prices from the AAPL option chain as the price of the stock is around $450. The deep in-the-money March 400 call is priced at $54; it consists of $50 of intrinsic premium and $4 of extrinsic premium. In contrast, the out-of-the-money March 500 call is priced at $2.60. It contains $0 of intrinsic value and $2.60 of extrinsic premium, or the entire price of the option.

One important consistent observation on the ratio of these premiums should never be forgotten because it is invaluable to remember in constructing potential trades. The at-the-money option contains the most intrinsic premium within any one expiration series. This occurs 100% of the time or ALWAYS.

Another important point to realize, another characteristic about which there is no argument, is that the extrinsic premium goes to essentially 0 at expiration. Furthermore, there is a rapidly accelerating decline to 0 as the expiration date approaches.

My mental analogy is that the extrinsic premium is like a snowball rolling downhill; it starts slowly, gains mass, and rapidly accelerates as the end of the slope (the expiration date) approaches.

While in previous times this vanishing of extrinsic premium was confined to a single monthly cycle, the recent advent of weekly option cycles has come to mean this is a weekly event. The final smell of burning extrinsic option premium as it goes to 0 occurs every Friday for the most active issues!

The logical extension of this daily decay of extrinsic premium has a practical implication every Friday morning. Extrinsic premium that is present for options series expiring that day will go to 0 by the closing bell. Read that again! This weekly occurrence has great profit potential for your trading.

As an example of the power of this mandatory decay, let us consider last week’s closing action in the XOM weekly option series. As we have discussed before, XOM has a hugely active options series, trades in both monthly and weekly expiration series, and has bid / ask spreads that are just a few pennies wide. It is, in short, close to an ideal option trading candidate.

XOM reported earnings shortly before market open on Friday, February 1st. The stock initially sold off to $89.40 from its previous close at $90.24. Shortly following this bottom, the stock manifest an intraday rally and the option activity was tightly focused within the first hour of market activity at the 90 strike options which were to expire that day.

02/01 XOM Intraday Price Chart


02/01 XOM Option Chain

This strong, clear, and tight focus of options activity was a highly predictive factor that XOM would “pin” the 90 strike for the day.

At the time that XOM was slightly below $90 and the extrinsic premium existing in the 90 strike puts contained an extrinsic value of $0.28 and a total price of $0.32. I sold the 90 puts with only a few hours of life remaining until expiration. Within a few hours, XOM traded to a few cents above $90 and I was able to close these puts for $0.12.

This highly successful trade benefitted from both the resurgence in price correctly predicted earlier by the tightly focused options activity at a single strike price and by the relentless decay in extrinsic premium toward 0 as the expiration bell approached.

Happy Option Trading!

If you are looking for a simple one trade per week trading style then be sure to join www.OptionsTradingSignals.com today with our 14 Day Trial.

 J.W. Jones is an independent options trader using multiple forms of analysis to guide his option trading strategies. Jones has an extensive background in portfolio analysis and analytics as well as risk analysis. J.W. strives to reach traders that are missing opportunities trading options and commits to writing content which is not only educational, but entertaining as well. Regular readers will develop the knowledge and skills to trade options competently over time. Jones focuses on writing spreads in situations where risk is clearly defined and high potential returns can be realized. 

This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.  

 J.W. Jones Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules