In-the-money (ITM) options typically have lower time value compared to at-the-money (ATM) or out-of-the-money (OTM) options on the same underlying for the same expiry dates. Is it then optimal to buy ITM options instead of ATM or OTM options? This week, we discuss the trade-off between liquidity and time decay when you trade options.
Liquidity Vs Time Decay
Consider the 19100, 19200, 19300 and the 19400 next week calls on the Nifty Index. With the index currently at 19322, the time value is 82 points for the 19100 strike, 103 points for the 19200 strike, 138 points for the 19300 strike and 105 points for the 19400 strike.
Given that the time value of all the strikes will decline to zero at option expiry, the 19100 strike is meaningful from a standpoint of time decay as it has the lowest time value. Suppose, you expect the index to move to 19500. If the Nifty Index hits your price target at expiry, the 19100 strike will carry 400 points of intrinsic value. Your net gain will be 96 points (400 less 304 cost) for a total of 4,800 for one contract.
But what if the Nifty Index touches your price target well before expiry? You may find it difficult to sell the 19100 strike. The reason is the high absolute price — 400 points of intrinsic value plus time value. And even as you are holding the option, the Nifty Index could reverse its uptrend and erode significant portion of unrealized gains on the position. ITM options may carry low time value than ATM or some OTM options, but low liquidity could mean that you may be unable to always capture higher gains arising from lower time decay.
Suppose you buy the 19400 call, and the Nifty Index reaches your price target three days after you initiate the position. Your position could gain 74 points. In contrast, the 19100 call could gain 129 points. If the Nifty Index were to reach the price target three days before expiry, the 19400 call could gain 34 points whereas the 19100 strike could gain 107 points. The 19100 strike dominates the 19400 strike in both scenarios. But as mentioned earlier, you may be unable to sell the 19100 strike if the Nifty Index reaches sooner. Therefore, if you trade options and you expect the underlying to move quickly in your preferred direction, near-ATM or immediate OTM call is preferable. If you expect the underlying to move to the price target near or at expiry, then you could consider buying ITM calls as loss from time decay is lower.
The motivation behind long position in ITM calls is comparable to that of long futures position; you are not concerned if the underlying reaches your price target at or near expiry. Of course, if you are confident about the trend, futures contract is more profitable, as it has a delta close to one.
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