premium. How fast can it go to zero without the movement hurting me? To
determine this, the trader must study both theta and delta.
The first step in the process is determining which month and strike call to
sell. In this example, Harley-Davidson Motor Company (HOG) is trading at
about $69 per share. A trader, Bill, is neutral to slightly bullish on Harley-
Davidson over the next three months. Exhibit 5.7 shows a selection of
available call options for Harley-Davidson with corresponding deltas and
thetas.
EXHIBIT 5.7 Harley-Davidson calls.
In this example, the May 70 calls have 85 days until expiration and are
2.80 bid. If Harley-Davidson remained at $69 until May expiration, the 2.80
premium would represent a 4 percent profit over this 85-day period (2.80 ÷
69). That’s an annualized return of about 17 percent ([0.04 / 85)] × 365).
Bill considers his alternatives. He can sell the April (57-day) 70 calls at
2.20 or the March (22-day) 70 calls at 0.85. Since there is a different
number of days until expiration, Bill needs to compare the trades on an
apples-to-apples basis. For this, he will look at theta and implied volatility.
Presumably, the March call has a theta advantage over the longer-term
choices. The March 70 has a theta of 0.032, while the April 70’s theta is
0.026 and the May 70’s is 0.022. Based on his assessment of theta, Bill
would have the inclination to sell the March. If he wants exposure for 90
days, when the March 70 call expires, he can roll into the April 70 call and
then the May 70 call (more on this in subsequent chapters). This way Bill
can continue to capitalize on the nonlinear rate of decay through May.
Next, Bill studies the IV term structure for the Harley-Davidson ATMs
and finds the March has about a 19.2 percent IV, the April has a 23.3