Time consideration when buying Short-term vs Long-term Call Option
In my previous post, I wrote about, At the money / In the money / Out of the money call option, basic definitions, and the 6 factors that determine the option pricing.
I remind you that options pricing is based on the partial differential equation from the Black–Scholes model, the solutions to this equation are not linear, which means it is hard to visualize how the option price will behave.
A short explanation about “time premium” and “intrinsic value” and “premium”.
To buy an option you pay a “premium” the price of the option contract.
The premium is the combination of time premium and intrinsic value
Out of the money and At the money only have time premium. (intrinsic value is zero)
At the money options have the most time premium.
In the money options have intrinsic value and time premium.
The intrinsic value of an In the money call is the amount by which the stock price
exceeds the striking price. For example, the strike price of the option $90, the stock price $100, the intrinsic value is 100-90 =$10. To this, we add time premium for this example we assume $1, The Total price of the In the money option, called premium is $11.
Theta is a measure of the time decay of the options. This is the risk measurement of time on the option position. Theta is usually expressed as a negative number, it is expressed as the amount by which the option value will change.
For example, an option bought for $7 and have 14 days until expiration, the theta of the option could be (-0.5), which means the option will lose half a dollar per day if all the other variables stay the same.
The options trader should know that time is the enemy of the option buyer and a friend to the options seller. (Options selling will be explained in another post)
Long-term options (one year for example) are not influenced by time decay in one day’s time. The theta of a long-term option is close to zero.
Short-term options, especially At the money options, have the biggest theta because they are the most exposed to time decay (The less time you have, the more rapid you lose time premium). At the money have the most time premium, do not get confused with premium (“time premium” and “intrinsic value”), Out and In the money options have less time premium.
The time decay (theta) of options on a very volatile stock will be higher than of options on a low volatility stock. The volatility of options will be explained in another post, but what you should know, the higher the volatility of an option the higher the price is (more “expensive”). The higher the price, the more time premium the option has, therefore more time premium to lose daily, which means those options have higher theta.
I want to note again, that the equation and their solutions are not linear, options will lose more of their daily value near expiration.
Chart explanation and conclusions:
We see two options in TSLA, short-term, and long-term, the faded colors belong to the short-term and the strong colors to the long-term.
Differences between the options, the option price, the days to expire, the volatility, and other “greeks” like the delta. The strongest factors, stock price, and the strike price of the options are the same.
We can see that the long-term options have a much sharper angle (more flat) than the short-term angle, meaning the time decay of the short options is much greater as we expect.
The profit lines (3,2,1) of the long-term options are above the short-term options.
The break-even and the loss lines of the short-term options are above the long-term options.