An extended weekend break due to a public holiday is normally something you would be eagerly looking forward to. The opportunity to unwind, relax with family and friends, or even to get those odd jobs completed, mean you don’t need to be at work. For the average trader or investor, it also means the stock market is closed and the opportunity to see your invested capital rise is limited. Or is it?
There are two absolutes I can state about the stock market:
- I have no idea what a share price will be tomorrow (I’m no Nostradamus), and
- Time will pass.
How to Approach the Stock Market
It’s this second fact that I want to explore, and provide you with some ideas on how you can approach the stock market.
Using derivatives, that is an Exchange Traded Option (ETO), there are a number of pricing components that can provide an opportunity to benefit from various aspects of stock market activity.
Certainly, the simplest is a change in underlying price. Such as if you buy shares and the share price rises, then you can make a profit from the position. Of course, the Risk is that if the share price declines, you will lose value as well.
Price analysis of an ETO can be influenced by changes in the underlying stock price, changing Implied Volatility, Interest Rates, and Time until Expiration. The more time until expiration, the less certainty there is towards where the share price might be at termination of the contract.
The less time until expiration, the more confidence the trader might have – however, you could still not be absolutely certain.
But Time Decay is a given. You cannot stop it. Between today and tomorrow, the value of an option will decrease in Time Value irrespective of all the other influences. Even when the stock market is not open, the value of the option is influenced by Time Decay. And for this very reason alone, I love public holidays.
In the world of option analysis, we can adopt strategies that benefit from Time Decay. This improves our probability of trade if all other factors remain equal. Of course, there is always Risk when it comes to investing, and just because Time Decay is a given, does not mean that a change in underlying stock price, Implied Volatility, or Interest Rates won’t influence the option price.
Covered Call and Credit Spread
Two of the most popular Time Decay strategies are the Covered Call and the Credit Spread. We have numerous articles online discussing the benefits and approach to using the Covered Call strategy. Credit Spreads provide the same outlook to the Covered Call, but do not require buying stock and provide the ability to have a Neutral to Bearish view of the underlying price as well.
Of course, these strategies have a Risk if the share price moves against you. For the Credit Spread, your maximum potential Risk is calculated when you entered the trade (just the same as investing in stocks or the Covered Call), so you have a predetermined amount of capital at Risk.
These strategies have been used for decades and extensively studied. As the extended long weekend for Easter, and in Australia the additional long weekend for ANZAC day falling within the same month, the April/May period is always a favourite time to adopt Time Decay strategies such as the Covered Call and Credit Spread.
Safe Investment Practice
Safe investment practice is to use Diversification – to spread your Risk amongst various stocks to alleviate the Risk of an individual company. Our view is that you should also Diversify your strategy approach as well. Reason being, if you invested in stocks only, then you are at Risk of the stock market falling. The heavier the fall, the greater the impact on your portfolio.
Hence, by adopting various strategies into your portfolio you can help to alleviate different market risks, whilst still maintaining exposure for the opportunity to make a return.
If you would like to know more about Time Decay strategies or how you can reduce your portfolio Risk, click here to book in a free consult with one of our advisors.
Matthew Brown – US Stocks & Options specialist
US Equity & Option Client Advisor
Halifax Investment Services
ASIC Australian Financial Services License Number – 225973
Matthew is an Authorised Representative of Halifax Investment Services (Halifax). Halifax provides broker services, including Full Service and Discount Services using multiple trading platforms.