A topic that is brought up more often than you might think in my Group Coaching class is buying outright call options and put options. When option traders first learn about trading options, they often only consider buying call options for a bullish outlook and put options for a bearish outlook. I know I did as a young retail option trader. In their and my defense, we were new so not knowing advanced strategies limited the option strategies available to trade. Choosing to buy call options and put options is the most basic of all option strategies, and more often than not it may not be the best choice.
What Are Call Options?
When an option trader buys a call option, he or she has the right to buy the underlying (usually stock or an ETF) 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 underlying, doesn’t mean 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. When selling a call option, the option trader has the obligation to sell the underlying to the buyer at the strike price up until expiration if he or she desires to do so (called exercising their right).
What Are Put Options?
When an option trader buys a put option, he or she has the right to sell (or sell short) the underlying (usually stock or an ETF) at a particular price (strike price) before a certain time (expiration). As is the case for the owner of a call option, just because the option trader has the right to sell the underlying doesn’t mean he or she has to necessarily do so. The put option can be sold anytime up until expiration for a profit or loss. When selling a put option, the option trader has the obligation to buy the underlying from the buyer at the strike price up until expiration if he or she desires to do so (exercising their right).
Examples of Short-Term Call Options
Option traders may fall in love with call options and especially short-term call options because they are cheaper than call options with longer expirations. We can classify short-term call options as call options that expire in three weeks or less 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 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. This is another example of a trade-off in option trading. The more time till expiration the more expensive the option and higher the risk, but the time decay will be slower. The shorter the expiration the cheaper the option and lower the risk, but you will have faster time decay.
Example of an Outright Call Option
With the stock trading at $43.43, an option trader has done his research and thinks the stock will move higher over the next couple of weeks. He looks at the option chain and considers buying a 40 strike call for either January or February expiration as seen below.
He could have purchased the Dec-24 calls for 2.15 that expired in 9 days. Yes, the options are cheap in comparison to the February options below and, yes, they will profit if the stock moves up vigorously in the next couple of days. But the option theta is -0.16 (rounded up) on the call options meaning they will lose $0.16 for every day 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 February calls, it would have cost him 7.60 and it would have made the at-expiration breakeven point of the trade $52.60 (45 + 7.60) versus only $47.15 (45 + 2.15) with the Dec-24 call options. But the major benefit to buying further out is option theta. The February 45 calls had an option theta of -0.06 (rounded down), meaning for every day that passes the option premium would decrease $0.06 based on the option theta and all other variables remaining constant. This is certainly a smaller percentage of a loss based on option theta for the February options (0.8%) versus the Dec-24 options (7.4%) especially if the stock trades sideways or moves very little.
In addition, the February calls have a positive delta of 0.57 and would gain about $57 for every $1 the stock moved higher. The Dec-24 calls would only gain about $44 from a $1 move higher based on the positive 0.44 delta for the same 45 strike. Bigger positive delta and smaller negative theta on the February calls seems tough to beat.
Wrapping This Up
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 or put option with more time until expiration will certainly cost more than one with less time but the benefits, including having a smaller option theta and most likely a bigger delta, might be worth the more expensive price especially if the underlying fails to move much.
Senior Options Instructor
Market Taker Mentoring, Inc.