The Argument Against Buying Low Delta Options
I usually don't like to buy an option with a low delta unless I am covering (hedging) myself against a significant stock movement/loss. (Such is the case when using a protective put.)
There are two main reasons why, and both reasons spell a higher risk with lower delta. The first is one that most people understand; the second is what many people overlook.
1) The lower the delta, the more extrinsic value your option contract consists of.
Extrinsic value (aka, time value) is what is left over after calculating intrinsic value. Extrinsic value is affected by time decay.
Intrinsic value is the amount by which your option is in-the-money. Intrinsic value is NOT affected by time decay.
If I own a Schering-Plough (SGP) Jan 20 Call, with the stock trading at $22.50, then my call option is $2.50 in-the-money.
If that SGP Jan 20 Call is trading at $3, then $2.50 of that $3 is intrinsic value, and the remaining 50 cents is extrinsic value and is exposed to time decay. (Keep in mind that these are not recommendations. They are examples to illustrate the power of delta.)
Remember: The extrinsic value (or time value) portion of an option is at the mercy of the clock. Time decay has zero effect on the intrinsic value portion of my options premium. That's why we like to trade in-the-money options that have minimal extrinsic value.
Notice in the table above that the percentage of the value of the option contract, that is, extrinsic value, increases as the delta decreases. So, the lower the delta, the more extrinsic value exists. And that extrinsic value is at the mercy of time decay.
For example, the extrinsic value of the Jan 17.50 Call (with the highest delta of 0.97) only accounts for 5.7% of the entire value of the option. This means that only 5.7% of the value can be lost due to time passing. Any other loss in the option would have to do with the actual stock moving lower.
Twenty percent of the Jan 20 Call is extrinsic value and is therefore at the mercy of time decay. The other two options have 100% extrinsic value.
Now, just about every options trader understands that time decay occurs as time passes, and most are familiar with what a time decay curve looks like.
The deterioration of the extrinsic value portion of the call option's value accelerates, especially in the last 90 days before expiration.
By purchasing an option that has a high delta, I can significantly reduce the effect that time decay has on my option's value (or premium).
