Why Buying an Option Can Beat the Odds
If you want to trade options, it’s important to understand that if you buy an option, time works against you. And if you sell an option, time works for you. But below, I’ll explain why options buyers can still come out ahead.
An option’s value consists of intrinsic value and time value. Intrinsic value is what the option is worth if exercised now. So an out-of-the money option would have no intrinsic value; no rational person would exercise it.
The more time there is left to expiration, the higher the time value because there is a higher probability that the option will increase in value. If you compare two call options (for the same stock) that have the same strike price, you will notice that the one with more time left to expiration will have a higher price than the one closer to expiration.
Time Value Decay
With the passage of time, time value decreases.
Time value doesn’t decrease in a straight line over time. In general, a rule of thumb is that an option will lose a third of its time value in the first half of its life, and the remaining two-thirds in the second half.
As you get closer to expiration, the underlying stock price will need a bigger and bigger move to meaningfully boost the price of the option, so the erosion of time value accelerates as expiration approaches.
It is because of time value decay that it is possible to be right about the direction of the underlying stock but still lose money on the trade. For example, let’s say stock XYZ is trading at $50, and you think the stock will go up so you buy a September 53 call. You pay a $1 premium.
Unfortunately, XYZ treads water and only gets to $52 at option expiration and your call option is worthless.
Even though you were right that the stock would go up, it didn’t make a big enough move to make money for your option trade. Also, even if XYZ moved above $53, because of the $1 premium, you would need XYZ to be at least $54 at expiration to not lose money (ignoring commission cost).
Of course, in our example, between now and expiration depending on XYZ’s movement and market expectation, you may have a window to sell the option at a profit. However, the point stands that in general, as an option buyer, not only do you have to be right about the direction of the stock, you also need the stock to make a sizeable move.
The Benefit of Buying an Option
Why buy an option then?
The advantage to buying an option is that you have limited risk but your potential gain is much greater. It’s very possible to be unprofitable in most of your trades but still make money overall.
Let’s continue with the XYZ September 53 call example. If you bought one option at a $1 premium, your cost would be $100. In the worst-case scenario, all you lose would be that $100. (In practice, between now and expiration, you could sell to close the position to cut your loss, in which case you won’t even lose 100%.)
But let’s say you make this exact trade four times, and lose 100% in your first three tries, for a total loss of $300. However, the fourth time things work in your favor, XYZ rallies to $58 at expiration. Your gain at option expiration would be $400 [($58 – $53 – $1) x 100)], four times greater than your maximum potential loss.
Thus, at the end of the four trades, you still made a $100 profit despite only being profitable 25% of the time.
On the other hand, sellers have limited profit but theoretically unlimited loss. This is why un-hedged option writing, like selling a naked call is dangerous.
In real life, experienced option traders will strategically open multiple option positions to manage risk. It’s quite possible to lose on certain legs of the trade but still make money overall.
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