Now the thing is, when you’re looking at a call option, the problem with it is the time decay factor. That’s one thing that you want to be aware of as you get into this business.
Eventually, you can use time decay in your favor. But at the beginning, most people that start out with option trading, they buy the calls and puts and their time decay works against them.
So let me share with you how the option contract really works. Initially, if you’re interested in let’s say trading Apple.
You could go in and buy the stock. In this case, the stock could cost you about $31,000.
That’s about a about a hundred shares of exposure.
Now what you can do with the option contract is you could buy a single option contract and instead of doing a hundred shares. Here we’ve got a delta of 99.79, which means it moves like a hundred shares of stock.
But we’re only paying 2,115 dollars for this.
So that’s the way that the Delta works.
If it goes up 2 dollars, 2 times 100, it should be about 200 dollars. Now to do this trade, it costs you almost 32,000 dollars. If you wanted to go ahead and do this in options and mimicked my delta that is very similar to one hundred.
It’s the same thing if it goes up a dollar, you make about about a hundred dollars.
So it’s very close to the stock but how much does this cost me? Instead of $32,000, this cost me $2,000. A lot cheaper to get the same exposure.
Now what’s the caveat? There’s no given ease in the market. Well the problem here is, you have time value that works against you look at this right here.
You’ve got -31.37 dollars per day that it costs you to hold this and that is exponential. That’s why the curve is there rather than a straight line.
So with time, you can see I’m losing my profit/loss.
If I go to the next day, I’m losing another 31 dollars.
That continues to accelerate. It’s an accelerated time value. It’s exponential and it’s not linear. Whereas with a stock, you don’t have any theta problem or time problem.
So in this case, you could basically just pull down the stock forever. That’s kind of the difference. So when we look at kind of what’s happening. Here is you have an option call contract.
This is known as our expiration line. You also have a T+0 line.
At the bottom we have the price of the stock. So if the price of the stock is 150 and that expiration or today at expiration I would be down 800.
Anything above zero, I’m making money. Anything below that zero, I’m losing money. So when you look at this call contract and you bought it and the stock price goes up to 190 well over here.
You can match it up and it’d be about $1,200 if it went up today. But if that was that expiration, it wouldn’t be as much. So you can see, it will be a little bit different.
If we look at this on our trade panel here and we go in and look at this right here.
If the stock here goes to 350, here’s my today line this is the white line.
I would make about 4,574 dollars. But if that was that expiration, it would be a lot less. So you can see my profit here would only be about 2,430 dollars, so about half less.
Time value is very important in these things.
Short duration versus Long duration
In shorter duration, what’s gonna happen is you have a fast time decay that works against you but it’s cheaper. A longer duration time doesn’t affect you as much but it’s more expensive. So there is always a trade-off in the market.
Which one is better? It all depends. It depends what you’re looking for.
Do you want to pay more for that insurance premium or for the contract. You’re basically getting into this position looking for it to make a move higher. That way you can capitalize from it but with time, what you have is that time value problem works against you.
Can you just buy this stock as an alternative?
You could and that’s what a lot of people do. Unfortunately, it’s not always the smartest approach because of the time premium problem. Think about it like your internet company or insurance company.
When you make money as an insurance company or as an internet provider, people are paying you either to insure you or for your service.
Well when you’re buying this call contract, you take money from your pocket and you give it to someone else.
You’re buying a call contract you’re buying something. What we normally do when I look at working with people is we talk about net selling.
This is called an Iron Condor
You can see we have two vertical spreads here and in this setup is we have time value that works in our favor.
So you can see here, I’ve got a theta of positive 8.62. Whereas when you look at our Apple situation here, we’ve got a -30.
We lose thirty dollars a day with time. Whereas here in this situation.
Every day, as long as it’s in that range, you make 8 dollars a day.
What’s the downside to this?
The downside is if the stock explodes to the upside, you don’t make unlimited amount of money as you would maybe with buying a single call. A lot of people that get into trading, they want to look at the unlimited had potential. But as you know, stocks don’t go up forever. They don’t go up like a rocket ship and they don’t go to the moon.
I mean sometimes some stocks do move pretty quickly but it’s not always the case. What people do is they usually dream about putting in 2,000 dollars and if that’ll go up, a little bit you know I’ll make 14,000.
It’s a good dream but it’s not always the case. It’s not gonna happen and it’s not that easy.
You must trade smarter.
This is the way that money is made when you’re dealing with call contracts. If you got to buy it and it’s got to move quite a lot to offset the loss of the time value. Even if it does move in your favor.
So here’s the thing, stock standstill here.
What’s gonna happen? You’re gonna lose money because of the time value. Stock moves down, you’re gonna lose money. Stock moves up slowly, you’re gonna lose money because of the time decay.
It’s got to move up a lot and really quickly for you to make money on these types of trades. That’s why a lot of people lose money trading options. They just do this single approach.
It’s the easiest to understand but it’s not really the most successful or smarter approach. So you can see that in most situations here, you’re gonna be losing.
Whereas if you look at this spread, here’s an iron Condor spread.
Well if this stock stands still, you make money because you have a positive theta. You have a positive time decay.
So that white line will get closer to the green line. If it moves down, you still can make money. You still make theta as long as it doesn’t go down past this level.
If it goes up, the same thing, you still make money because you’ve got positive time decay in time value.
What’s the problem with this trade? Well compared to the other trade, it’s capped.
You have been a net seller so you’re capped on your max profits. So if I look at this trade, the most I can make is 495 dollars. That’s the max I can make on a margin of 1505.
When you look at this percentage-wise, that’s still quite a good percentage as long as you can kind of stay in that range — about $500 on about 1505. But you’re not gonna make unlimited amount like you would with a call option.
As you trade more and more you’ll realize that stocks really don’t go up forever. They’re not gonna be like rocket ships. Sometimes they do but in most cases they’re not.
I would rather be a have a much more successful trade of more consistency than try and shoot for the moon like many of those other types of things.
That’s what happens with a lot of people as they try to shoot for a call side here.
They try to do the same thing on the put side. They’ll go ahead and set up a put contract here to try and bet on the stock going down. They get into these things thinking as long as it moves down, your gonna be good.
Even if it moves in their favor sometimes it does work out. But it moves days later, then what’s gonna happen is you’ve got this time decay problem. That works against them. It happened so much later that your profits eroded quite a bit.
So be very careful with doing these types of trades and setups because they can bite you. Most people do these when they’re new and setting things up.
So anyways I hope this was helpful gives you an idea of how money is made with call contracts.
That’s kind of the way that it would work but again there are better ways to do that.
As you become more familiar with how these things work, this isn’t always the smartest approach. But this is typically the most common approach that people take at the beginning.
So it’s a good step in your journey but there is another level.
