Demystifying the Time Decay Attributes of Options
April 28, 2008
One of the most important concepts an options strategist must master before having a chance at being successful is time decay. Options are considered wasting assets in the sense that they expire after a certain period of time. As each day passes, the time to expiration decreases and the time value premium also decreases. To better understand this concept, you need to know what is meant by time value and intrinsic value as they pertain to option trading.
Time value, also referred to as extrinsic value, represents the amount the current market price of an option exceeds its intrinsic value. Intrinsic value is the amount by which an option is in-the-money thus out-of-the-money and at-the-money options have no intrinsic value just time value. There are four major components that have an influence on time value, which include time to maturity, interest rate, volatility of the underlying asset, and liquidity.
A very important point about the time value of an option is that as it approaches expiration it decays at a very rapid level. In other words at a certain point close to expiration, the near expiration options time value will move exponentially meaning the closer an option gets to expiration, the more money it loses if the market doesn’t move in the direction that places the option in-the-money.
On the expiration day, all an option is worth is its intrinsic value, its either in-the-money or it is not. The further out from the expiration date the option is, the smaller is the impact of time decay, which is greatest in the last 30 days. These characteristics of time decay are extremely important to remember when trading options because they can be used to your advantage.
To illustrate this concept consider a situation where the trader has purchased long options. In this situation the trader is susceptible to time decay in their options if the stock moves sideways. For each day the stock does not move, their option loses value. This loss in value is smaller the further out the trader goes out in time. The best way to reduce the impact of time value on their long option position is to use options with as much time to expiration as possible based of course on their original risk to reward requirements.
When purchasing a long call or long put, for example, you want to have as much time as possible not only for your option to move in-the-money, but also to reduce the impact of time decay in case the underlying stock moves sideways for a period of time.
Most traders do not understand this concept of time value or time decay because they think in short term. When a stock is expected to move, many novice option traders fall into the habit of buying options with less than 30 days to expiration because they are the cheapest. Using long term options will reduce the effect of time decay greatly and therefore allow you to wait patiently for the expected move in the underlying stock without watching your position or money decay.
Just as option strategist can use time decay in their favor with the purchase of long-term options, they can also use time decay to their advantage by selling options. When selling options, the goal is for the option to expire worthless or buy it back at a lower price for a profit.
The option strategist should always sell shorter options with less than 45 days to expiration. Time decay works to the option strategist’s benefit on a short-term short option because it decreases the option’s value, thereby producing a profit for the short seller. Keep these impacts of time decay on both the long and short option positions firmly in mind before an actual option strategy is selected and implemented.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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