When an option trader buys a call option, he or she has the right to buy the underlying at a particular price (strike price) before a certain time (expiration). Keep in mind that just because the option trader has the right to buy the stock, doesn’t mean that he or she has to necessarily do so. The call option just like a put option can be sold anytime up until expiration for a profit or loss.
A lot of traders especially those who are just learning to trade options can fall in love with call options and especially short-term call options because they are cheaper than call options with longer expiration’s. We can classify short-term call options as call options that expire in less than thirty days for the sake of this discussion. But there is a potential problem with purchasing short-term call options. The shorter the amount of time that is purchased, the higher the option theta (time decay) will be. The higher the time decay, the quicker the premium will erode away the call option’s premium. The call option may be cheaper due to a shorter time until expiration, but it may not be worth it overall. Let us take a look.
With Tesla Motors (TSLA) trading around $235 last week, an option trader might have considered call options to profit from an expected move higher. He could have purchased the December 235 calls for 2.80 that expired in 3 days. Yes, the options are cheap and yes they will profit if TSLA moves up vigorously in the next couple of days. But the option theta is 0.70 on the call options meaning they will lose $0.70 for everyday that passes with all other variables being held constant, In fact if the stock trades sideways, the option theta will increase the closer it gets to expiration since there is currently no intrinsic value (the in-the-money portion of the option’s premium) on the call options.
If an option trader purchased the January 235 calls for TSLA, it would have cost him 11.00 and it would have made the at-expiration breakeven point of the trade $246 (235 + 11) versus only $237.80 (235 + 2.80) with the December call options. But the major benefit to buying further out is option theta. The January 235 calls had an option theta of 0.18 meaning for every day that passes, the option premium would decrease $0.18 based on the option theta and all other variables being held constant. This is certainly a smaller percentage of a loss based on option theta for the January options (1.6%) versus the December options (25%) especially if the stock trades sideways or moves very little.
Fast forward a couple of days to December expiration and let’s pretend TSLA closed basically at $237. The December 235 call would have expired with an intrinsic value of $2 (237 – 235). If the option trader did nothing up until expiration, the long December 235 call would have lost $0.80 (2.80 – 2) because there would be no time value (option theta) left and only the intrinsic value. The January 235 call would have lost approximately $0.52 (3 X 0.18) in theta but also gained $1 (2 X 0.50) from delta based on a delta of 0.50 and a $2 (237 – 235) move higher. The January 235 calls would now be worth $11.48 (11 + 0.48) and profited $0.48 (11.48 – 11).
Having enough time until expiration is a critical element when an option trader is considering buying options like the call options we talked about above. Keep in mind that as a general rule, options lose value over time and the option theta starts to accelerate even more with 30 days or less left until expiration. Buying a call option with more time until expiration will certainly cost more than one with less time but the benefits, including having a smaller option theta, might be worth the more expensive price especially if the underlying fails to move higher.
Happy Holidays and Merry Christmas!
Senior Options Instructor