So much of what we do is based on price — goods and services, our labour, and everything else we buy. The same applies to the stock market. Checking out a stock price lets us know immediately how much we’ve made or lost.
For investors who use stop-losses, they’ll typically choose an exit based on price too. If a stock falls to a certain price level, that’s proof that the trade is no longer valid. The reason for holding the stock no longer exists, so they’ll get out of the trade.
However, one of the shortcomings of using a price-only-based approach is that it ignores something else that is equally important…time.
If we judge the success of a trade by the difference between our entry and exit price, we also need to consider how long it takes to generate that return. Without considering time, we don’t have a basis from which to judge if a return is acceptable.
Naturally enough, we all want to get the best possible return in the shortest amount of time. But what do you do when a share price goes nowhere?
Stuck in no-man’s land
Sometimes a share price can trade sideways, hitting neither a profit target, nor triggering a stop-loss. We know that the trade’s not working, but we don’t want to get out because of a basic fear. That is, the gnawing feeling that the stock might take-off the moment we get out of it.
We all have a limited amount of capital, so we need to deploy it where we can generate the best return. Using a time-based approach — a time limit — helps us prevent tying up capital in a trade going nowhere.
Often, professional traders will cut half their position if a trade doesn’t move in their direction. For a stocks trader, it might only be a couple of weeks. For a shorter-term futures trader, it could be a couple of hours.
If the trade is still going nowhere, they might choose to close out the whole position. They can always add the position back on again if the stock starts to move.
These professionals want to see evidence that they are on the right side of the market. Meaning that the weight of money is behind them. If the market doesn’t move in the direction of their analysis within their timeframe, they’ll look to exit the trade.
While using time as a parameter for share trading might not be familiar to everyone, option traders are particularly aware of it. For them, time sets the boundaries in which a trade must work.
A time-based approach
All options have one thing in common…expiries. From the moment an option is listed, it has a finite amount of time before it lapses. Time is constantly ticking away.
For an option buyer, the share price needs to move beyond the option’s strike price before it has any intrinsic value. For a call-option buyer, that means above the strike price. And for a put-option buyer, the share price needs to fall below the option’s strike price.
If the share price doesn’t get beyond the option strike price before expiry, the option lapses worthless. Before a trader buys an option, they need to believe that the share price can reach the strike price before the option expires, otherwise there’s no point buying it.
But options come with an added twist. And it’s to do with the way option prices are calculated. The closer an option gets to expiry, the quicker the erosion of the option time value.
Time becomes an ever more important factor as the option counts down to expiry. Because of this, option buyers and writers (sellers) approach their trading differently.
Typically, options lose two-thirds of their time value in the last half of their life. For someone who writes options, this is really important. They’ll look to capture as much of this time decay as possible. It’s what we look for at my advisory service, Options Trader.
Even if the share price was to trade sideways, time erodes the value of the option. Meaning that an option writer could buy the option back for a lower price that what they sold it for.
And for an option buyer, this time decay is working against them. They’ll typically look to close out a position more than 45 days before the option expires. They want to get out before time erodes the value of the option they’ve bought.
Even if a share price is rising, it’s possible that a call option could drop in value from the effects of time decay as the option runs into expiry.
Rather than fixating on price movements, we need to consider time in our trading — whether you buy shares, or trade in derivatives such as options and futures. Time puts context into the returns we generate. Time also helps us maximise the use of our capital by exiting a trade that isn’t working.
For Markets and Money