Why Buying Call Options After Selloffs Can be Costly

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If you’re an avid reader of The Options Bro, you’ll know that buying call options after selloffs is one of our favorite options trading strategies. We typically look to buy call options with anywhere from three weeks to one year until expiration on a stock or index that we are bullish on, especially if that stock or index happens to have a steep, panicked selloff.

Buying call options on the S&P 500 has produced favorable results for us in the past. In general, call options allow traders to maximize leverage and minimize the amount of buying power necessary to establish a long position. Simply put, we like the idea of buying calls as a method of getting long as opposed to buying stock or futures contracts to get long.

However, buying call options definitely doesn’t always result in a profitable trade, so let’s take a look at a real life example of a trade we recently placed that *somehow* lost money. Long story short, we spent $15,000 to buy 14 out-of-the-money SPX (S&P 500) call options after the S&P 500 tanked as a result of rising interest rate fears. Amazingly, when we exited the position, the S&P was 0.50% higher than when we bought the call options, yet we still lost $1,960, plus commissions, on the trade. Awesome. Let’s ascertain why.

Key Points:

  • Buying call options after selloffs is risky when implied volatility is high
  • Implied volatility is a major component to the overall price of a longer-term option
  • Typically, implied volatility for options heightens after a selloff
  • If the underlying asset rebounds, call actually lose value as implied volatility reverts
  • Options commissions need to be kept as low as possible to succeed in the trading business
  • Ally Invest offers some of the lowest commissions in the industry and free trades for new qualifying accounts

An Example of an Options Trade Gone Awry

On February 16, 2018, we purchased 14 out of the money call options on SPX (the S&P 500). The S&P 500 is comprised of 500 of the biggest and most profitable public companies in the United States and is the benchmark index for the overall stock market.

We figured the panic due to inflation fears and additional interest rate hikes was largely overdone, so we bought a few call options for roughly $15,000 with almost one year until expiration to express our bullish thesis. The trade did not go well.

We planned to hang on to this position for at least six months, because we thought markets were poised for a strong rebound. After we bought the calls, the S&P 500 declined substantially before it rebounded. During this time, the calls actually did not lose much value, if any at all because implied volatility increased substantially (more on this later). We saw other opportunities in the market and the rebound (which we accurately forecasted) was not as strong as we had hoped. As such, we dumped our position for a loss, even though SPX was trading higher than when we bought the calls.

This chart shows the precise time we entered and exited the position.

Upon entry, SPX was trading around $2,730. Upon exit, SPX was trading around $2,744, a full 14 points or 0.51% higher higher. Nevertheless, we roughly $2k on this trade.

Call buying on SPX

This screenshot of out account statement displays the time and price of our SPX trade. The first blue circle at the top of the statement is when we entered the trade, and the second blue circle is when we exited the trade.

Without including commissions, we lost $1,960. Including commissions, we lost a full $2,002 on this trade in a period of 11 days, which is incredibly irritating considering the S&P advanced 0.50% during this same time period.

What the Heck Happened?

So how did we manage to lose $2,002, roughly 14% of our position, on this one trade when SPX moved higher?

The simple answer is theta decay and implied volatility.

At the time when we purchased the SPX calls, the VIX index, which measures the implied volatility of S&P 500 options, was hovering around 19.59. When we sold our SPX calls, the VIX index was at 18.23. This means volatility decreased; subsequently, so did the value of our call options.

VIX declineThis 1.36 drop in the VIX equates to an almost 7% decline during the duration of our options trade. Even though the market climbed by 0.50%, the decline in volatility was enough to affect out long-dated options to the point where they were worth less even-though SPX advanced and the calls were closer to being in the money.

In addition to the volatility decline, theta decay really hurt our position.

Using Options P/L Analysis Tools

With the free options analysis tools from Ally Invest, we can adjust the days until expiration for any given options position as well as the level of implied volatility.

ALLY INVEST OPTIONS ANALYSIS

This graph displays the potential profit or loss for an example SPX long call option trade. The risk is only limited to the initial premium spent, and the reward is theoretically unlimited.

By adjusting the “Target Date” feature, you can wee what the theoretical profit and loss will be if the price or volatility level increases or decreases. As each day passes, long out-of-the-money options positions will lose value due to theta (time) decay. Because options will expire worthless if they are not in the money at expiration, they gradually lose value as expiration nears.

In the case of our trade, this is precisely what occurred. We lost money due to 12 days of theta decay, which equated to roughly $1,200, ($100 per day) and we lost money due to a volatility collapse, which equated to roughly $740.

An Easy way to Check Theta Decay

Before you buy or sell an option, you should always check to see what the theta decay levels are.

Using Ally’s options trading software, and if you haven’t learned by now, Ally is the best brokerage for options trading, it’s easy to see the theta levels.

Theta decay Ally Invest

Remember, theta decay is always calculated PER DAY. In the screenshot above, this SPX call options will theoretically lose $5.88 due to theta decay. This number will increase/decrease depending if the option becomes closer to the price of SPX or further from the price of SPX, respectively.

If you trade 10 contracts, with a theta decay of -$5.88, you can expect to lose $58.88 dollars every day if SPX stays flat, with all other factors being equal. This is the risk you take when buying options. The reward, however, is that if SPX doesn’t stay flat, and it moves substantially higher, the call options will exponentially increase in value. Of course, in our case, SPX didn’t move substantially higher; it only moved 0.50% higher.

Why Buying Call Options after Selloffs Can Cost You Money

Buying call options shortly after the underlying asset has a significant selloff is starkly different than buying call options after the underlying asset has been steadily rising. When markets are consistently rising, implied volatility tends to be low, because there is less fear and uncertainty in the market. As such, calls trade cheaper, and their value isn’t inflated due to implied volatility.

However, after a large sell0ff, the majority of investors panic and lose money (because the majority of the investors, institutions, pension funds, and hedge funds are long). And when they panic, they are willing, and sometimes obligated by investor bylaws, to purchase options to protect their portfolios against any further losses.

Therefore, if you buy call options as a method of getting long after a market pullback, chances are you are buying them at heightened levels of implied volatility, because implied volatility affects the prices of both call and put options. Of course, often times this is okay. Because when implied volatility is high, it means investors anticipate larger moves either up or down in the market.

If these outsized, abnormally large price moves are to the upside, buying call options at high levels of implied volatility can often be very profitable, as markets are forecasted to move up or down much more than they regularly would. The danger is when prices only move up minimally, compared to what they moved down by, and volatility decreases. This is precisely what happened to us when we purchased the SPX calls; we got skunked.

The Importance of Minimizing your Transaction Costs

Something worth underscoring here is how much we paid in commissions for this trade and how significant it was towards our bottom line.

Roundtrip, for 28 options contracts, we paid a whopping $42.00 in commissions. We wire transferred $15,000 into an account to test it out and we most likely will not use that account again because we overpaid in commissions.

Had we used a free trade promotion from Ally Invest, (like this one Start investing at Ally Invest and get a $200 cash bonus or 90 days of commission-free trades!) we would have had an extra $42.00 in our trading account. If we did 10 similar trades in one month, that would be an extra $420 we could have saved. Options trading commissions add up quick, and they need to be kept as low as possible if you want to succeed as a trader – period. It’s paramount to always remember this.

Final Thoughts

Throughout the past year, we have shared a few trading stories. Some of them good, some of them bad. Our article on turning $9,333.62 into $24,558.62 trading ES options was very popular, but we wanted to share an example of an options trade that didn’t result in a 150% gain.

In the business of trading, it is a simple fact that you will have losing trades. The key is to keep you losing trades smaller than your winning trades.

At the end of the day, for this trade, our timing was spot on and we were 100% right about the direction of the market, but we still managed to lose a few thousand bucks. Although being correct about our investment thesis offers some vindication, it’s indescribably painful to have an investment thesis that turns out to be correct and not only not make any money, but actually lose money.

Hopefully, our SPX trading example and being aware of theta decay, volatility collapses, and high options commissions can prevent or minimize any future losses if you decide to buy calls after a market selloff.

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