Understanding Price Curves of Long Options​

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Today we're going to talk about understanding the price curve of long options. There's a lot of misconceptions about option pricing itself and I'm going to get into it today. There's a lot of people that will never buy options because they have a belief that most options go out worthless and conversely, because of this belief, many people are actually led to sell options because they believe that most of them go out worthless. Today, we're going to focus on the long side and one of the reasons we want to focus on the long side is this is something that we teach a lot in our courses is that we can actually trade long options and we can generate amazing R multiples. Amazing multiples of reward to risk and one of the things we talk about is the secret sauce of great trading is being able to generate big winning trades. Most everybody wants to do the opposite. They want win rate, they want high win rate trades and whenever you go for high win rate, which makes you feel good. Usually, the downside of systems that have high win rates, is they have big losers. Because of this, we really focus on the opposite, we focus on having big winners and buying options is one of the ways to get really big winners. We're going to talk about this because to understand this, we need to understand the price curve of a long option. We're gonna work through two examples just to see kind of two different scenarios of how this plays out. 

The first scenario is a trade that a student of mine did and he bought the march 24, expiration 130 Call on Friday, March 17 2023, at $1.30 and he was expecting some fundamental news on the stock on Monday that would have the stock rally towards 140 very quickly. He was right. The stock closed on Friday at 122.69 and on Monday, it rallied to 131.17 off the news. The stock then rallied again on Tuesday reaching a high of 137.09, before falling back to 131.17. 137.09 ended up being a high of the week and the stock actually settled at 130.19 at expiration, leaving the calls with a value of 19 cents. One of the things that we can see is a table of the value of the calls. On the day that he went long, the calls actually settled at $1.03, so his called settled for a small loser, but you can see on Monday, they popped to $3.60 and then they actually never traded that value again, they declined all week before they expired at 19 cents and we can see this in the price curve. They peaked on Monday and then basically declined through the rest of the week, going out at 19 cents. This is a great example of how people get frustrated with long options. Because he had a belief, he had a thesis, his thesis turned out to be correct, the stock took off and at the end of the week, the call that he bought, the stock was up basically about $7.50 for the week, but his call was a loser. That's why people get so frustrated with long options. This happens a lot and so we're going to talk about this.

Now let's look at another example. Well actually, before we do that, I want to show something. So here's that same graph I just showed you, but what we do not see in this graph, is actually the highs and lows of each of the days. A lot of times when we're long options, we want to remember that being long an option has leveraged in it, especially when they're out of the money. What will happen is if your option starts to be correct, it starts to work, you'll get leverage on your side and the value of your option can explode. So here, the high of the move, as we said, was on Monday when the call settled at $3.60. What we do not see though is that on Tuesday when the stock went to 137.09 and made its high, the peak value on that day was roughly $7.50. When the stock ran to 137.09, the call was actually at that point worth, like $7.50. We look at the curve, the curve actually went parabolic and before then falling off. This happens a lot. So we're gonna talk about this here in a little bit. A lot of options will go parabolic and take off if you get the move in your favor right away. 

Let's look at another another example. This is in META, Facebook. In META, we go long the February 3 2023 145 call at 3.25 on trapping of long term volume. This is one of our patterns that we teach. Facebook then trends higher from this volume trap, all the way into earnings on February 1, in which there's a massive gap on earnings and February 1. The call, which we paid $3.25 for, is trading $11.23 the day before earnings. Earnings is a massive upside miss and META Gaps higher on the miss and these calls expire at $41.53 for an 11.77 R winner. These trades look great in premise, but the question is, can we actually get them? Can we actually hold them? This is a classic example of how some of these trades are difficult to actually realize the big win. Let's look at why.

In our table here, we have the value of the calls through time and one of the things we see is we go long on January 3, at 3.25 and basically what happens throughout the month is META just keeps going higher every day. It goes higher a little bit every day and you can see because it does that, that gets reflected in the value of the calls and calls are just kind of grinding higher every day. Now stocks up a decent amount each of these days, but these are out of the money calls. T stock has to continue to perform, or these calls are gonna lose value. The stock is performing and you can see the calls are going up every day, but soon as Facebook has a little setback in value, notice right here that in January 18 these calls, go back to 3.38. Now you only have 13 cents on these calls, even though that has been rallying throughout the month. This is very similar to what we saw in Sarepta, where the calls are working and then soon as the stock stops going up, they fall off. Now from here, it starts to rally again and now we see the value starting to go higher and then they said as soon as the stock backs off, they start to collapse again and then boom, here's earnings. You can see what's happening is the call is grinding higher, sets back, grinds higher, sets back and then explodes turning into a huge winner. 

So this is typical of how you see these long options work. You kind of have two scenarios when they work, you have one, in which they pop initially, and then they go back to zero, you have another with a pop initially and then eventually they keep going they turn into underlying and when they turn into underlying in this case, it turned into just being long META stock and at this point, every time META goes up $1, the call goes up $1. This is where this big leverage starts to kick in. Until your call can get into the money and not just in the money but like a decent amount in the money, it's going to be vulnerable to any setback where the values collapse. If you buy out of the money call and it works, you're gonna get a pop and value, could be a leverage pop where it really takes off, but if it doesn't keep following through, if it doesn't keep moving to being in the money, it's going to collapse and go back to where it came from and to zero. If it can get through, you get the initial pop, and if it can keep going and get through the strike that is going to become underlying and the further moves and underlying the more dynamic the trade is going to be because now you're making dollar for dollar on a much larger position or a much smaller risk however you want to look at it as underlying keeps going up. Let's talk about this.

As we said the belief is most options go out worthless so people completely discount the path of prices for an option that expires worthless, they just assume it goes from $5 to zero. If I sell it at five, it's five bucks. I had a friend of mine who was a trader that I trained and then I trained him again and he was part of this camp that said, there was never an option that was not meant to be sold and the reason was as well, if I'm selling a $5 call, it's out of the money, it's gonna go to zero. So why would I sell it? Well, it totally discounts this, which is that many worthless options, we see a call at five bucks, we see it expired zero, or in the case of Sarepta that we see it worth $1.30 and it goes to 19 cents at expiration. It looks like that's an easy trade, but what is missed is that many of these options actually explode in value, only to go back to zero. The case of Sarepta, it went from $1.30 to $7.40, back to 19 cents. This makes it difficult and dangerous, very, very dangerous, for the short option writer to stay short. This is why many people who sell options have a very difficult time actually realizing a profit. The opposite side, which we're talking about today is many long option holders wash their option accumulate significant profits, only to go to zero and then be really frustrated. Why is this, because as we said the price curve of a long option is dynamic because it has leverage embedded in the option. This is especially the case when there are out of the money options. 

How should we manage these positions. A great way to trade these is to predetermine a peel point on your option that allows you to capture any pop in short term gains, any pop in the price curve. What this will do is this will ensure you that your trade is made profitable, which will make it easier for you to hold the rest of the trade and let it run. This is second thing, working to sell options in the book ahead of time can result in excellent fills. There are algos running all the time in the option market. These algorithms are running all the time and they're looking at the value of an option relative to the underlying and anytime the underlying pops, these algorithms are going to be looking for Miss pricings. If you have an if you have an order out there, there's two ways it benefits you, one if the stock pops the algos are going to be looking to buy things that undervalue and they could sweep up your call just automatically take it. The second thing is sometimes you get people they get in a hurry to buy the option, so they'll pay up and they might pay up exactly into your into your offer. You get these surges in the book that you can sell into to give you a phenomenal fill.

Let's look at an example of how my student could have handled the Sarepta trade. He buys 10 Sarepta calls $1.30, so he's at $1,300 in initial risk. The student decides to sell 50% of the position by selling five of the 1.30 calls at three R, in other words three times his risk. So he paid $1.30, 3 times his initial risk is $3.90, so to make three times it's going to be $3.90 plus the $1.30 he paid. So it's going to work to sell half the position at $5.20. The student has an active order in the market good to cancel, it means he puts his order out there and he makes it good to cancel so it's working every day and then on Tuesday, March 21, when there's this surge in the stock to highs for the week, he gets filled he sells five calls at $5.20. Now when the stock rolls over, and the calls end up going out at 19 cents, he actually makes a total of 1.07 R, $1,395 in profit divided by the 1300 he risked. He took a trade that would have been essentially a one R loser and turned it into a one our winner by selling half at three R. I do not like to do these less than three R, lot of people do at one R and all this does is assure your best trades will be really mediocre.

We don't want to take trades unless we think we can make at least three R. That's our threshold where we can start to peel making sure we're capturing the gains from a decent winning trade. Now, in the case of Facebook, we could have done the same thing and this would have worked really well on Facebook, and META because we would have had a guaranteed profit going into earnings. Going into earnings can be really dangerous for your position, because you can't control with earnings are, you just don't know. Facebook took off, which was awesome, but it could also have collapsed, which would have been really bad. Had you peeled out of the position, you'd had a guaranteed profit locked in and then you could have just sat on the rest into earnings. The great part about this, you have a guaranteed profit, and you can just be easy knowing that the worst you can do is make money. This is a really useful way to manage long option positions. There's a lot of other little things around this we can do, but I wanted to share this with you today because if we can understand how the price curve works, we can use it to our advantage by putting these orders out in advance that basically allow us to lock in profits anytime we get a surge. 

Pay attention to this and check this out because this has the ability to radically change your trading. One of the things we always talk about is I'm trying to teach you how to trade in a way that puts you in a position of being psychologically strong. We never have to over worry about risk. This is a great example today of how to do that. I will see you next Tuesday with further tips and techniques like this that will help you take your trading performance to an elite level. Have an awesome week and God bless. Bye