Your option strategy payoff diagram is an ever evolving and changing animal. Unlike stocks, which have one-dimensional payoff graphs either upward or downward sloping, and theoretically unlimited holding periods, option strategies are impacted by cubic pricing events. Namely, time decay (Theta), implied volatility (Vega) and interest rates (Rho) which can cause your payoff diagram to shift, mold, and bend as these additional pricing elements change with the market.
In today's podcast, I want to help you understand how these three Option Greeks could have a significant impact on the way your payoff diagram looks now vs. at options expiration. In the end, I think it'll help give you more confidence and patience if you understand how option pricing works when holding positions that initially move against you but ultimately will turn out to be profitable.
Key Points from Today's Show:
- Most often, traders do not understand how payoff diagrams change and evolve over time.
- Three major aspects that impact your payoff diagram are time decay, implied volatility, and interest rates.
- When a price does not move the way expected, it is mainly because of the impact that time decay and implied volatility has on your position.
1) Time Decay
- Time decay is the slow change that starts to increase as you get closer to the expiration date.
- As you get further into the expiration cycle, time decay increases exponentially.
- At approximately 45 days it hits the apex of the curve and it starts to accelerate to expiration.
- If you are an options seller, this works to your advantage.
If you are selling options and get an initial move that is against your position, then you might have a paper loss for the time being. If that initial move does not continue, and it is lower or higher in the stock, that creates a paper loss but it still is not outside of your strike prices. Now you start to get the impacts of time decay as the stock just sits there and trades in a small range all the way to expiration. You will start to slowly gain some profit back on that position because time decay is starting to be drawn out of the value of these contracts.
*As an option buyer, if you make an initial move it will be better to close out early at a profit than to let it decay.
2) Implied Volatility
- The biggest impact on the payoff diagram comes from implied volatility.
- Most of the time, the reason that option contract values go up or down is because of implied volatility.
- If the market expects the stock to be more volatile in the future, then all options on both sides will increase in value.
- If volatility is high and drops rapidly, that can create an opportunity to close positions quickly in the expiration cycle — creates a payoff diagram that starts to mature much faster than it would take over a month of time decay.
3) Interest Rates
- When interest rates rise, the value of options will rise as well.
- If a trader decides to buy a call option instead of stock, that call option is worth less than actually buying stock.
- The options pricing models assume that the extra cash left over from not buying stock could earn interest some place else.
- The options contract factors in the potential interest that could be earned from not buying the stock.