Wednesday, February 23, 2011

AAPL $350 Call Price Erosion - Option Buying Nemesis

When I hear people talk about the options positions that they have on the table I usually hear them say, "well, I have six months before it expires - so, I have lots of time to make money."  The problem with that is represented in the graph that you see below.  Click on the image to see a larger version.  

One of the most important factors associated with options pricing is something called time premium.  Time premium is the amount of money that you have to pay due to the uncertainty associated with the future.  Nobody knows what a stock is going to do in the future.  Therefore, options premiums go up the further into the future they expire.  In the above graph I illustrate the effect that time has on the price of the $350 strike price call.  If you buy the February option that expires in two days, it will only cost you 87 cents.  However, if you buy the January 2013 option at the same strike price, it will cost you $64.  That is a drop of 99 percent in 693 days.  

Remember that in order to make money on a call option the market price has to be greater than your option price at the expiration date, assuming you hold until expiration.  So, if AAPL would have to be trading above $414 per share sometime between now and January 2013.  This is obviously possible, given the current trend.  The kicker, is that your option price will continue to decline every day between now and that expiration date.  Therefore, if the price stays at the same price for the next year or so, you will be looking at an option price that is much lower than $64.

So, the moral of the story is to only buy call options on stocks that are poised to make a strong move in the near future or the time erosion will take a big chunk out of your earnings potential.  

Let me know what you think!  Feel free to comment here or shoot me an email!