What Does Time Decay Mean for Options Traders?

Founder and CEO Bernie Schaeffer explains time decay

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    Time decay refers to the rate at which time reduces the value of an option. First, it's essential to understand that time decay is exponential and accelerates as expiration draws closer. The rate of acceleration is directly related to how far in the money an option is. So, if you own an in-the-money option, you want to pay close attention to the expiry and sell as soon as possible to have a maximum value related to time decay.

    Trying to understand how time decay works can be a little tricky at times and can be a reasonably complicated subject on its own. However, understanding what it is, what it means, and how it affects option prices is crucial if you want to succeed as an options trader.

    This article will provide you with an overview of time decay and how an option's price changes over time as expiration approaches. You'll also learn about factors that can influence how quickly an opportunity loses value as it comes to expiration.

    What Is Time Decay?

    Time decay is the natural reduction in an option's price as expiration approaches. Time decay increases an option's probability of expiring out-of-the-money. Since time decay is an inevitable price erosion, traders must be cautious when trading short-term and long-term options.

    Specifically, time decay refers to the reduction in an option's premium or price over time until the point at which it expires worthless. Time decay is a function of volatility, time remaining until expiration, and interest rates. While most traders are familiar with time decay, many fail to recognize that time value erodes in reverse fashion. As expiration approaches, time value gradually increases due to the increasing probability of an option reaching its strike price before the expiration.

    Time decay is calculated by subtracting the stock price from the strike price and dividing it by the number of days until expiration. For example, if XYZ stock is trading at $39 and you're considering buying a call option with a strike price of $40, you'd use this formula: ($40 - $39)/365 = 0.078 or 7.8 cents per day. This means that your $40 call would decline in value by 7.8 cents for each day that passes until expiration.

    Time decay is affected by several factors, including stock price and tick value. The higher the stock price, the slower the rate of time decay since there's less money left on the table if the stock moves in your favor after you buy your call option. The smaller the tick value (size of each move), the faster time decay will occur since it's easier for stocks.

    What Does Time Decay Mean?

    The time decay of an option contract erodes over the life of an option contract. More specifically, for call options (i.e., options that give you the right to buy), time decay negatively impacts the call price, whereas, for put options (i.e., options that give you the freedom to sell), time decay positively impacts the put price.

    Time decay is a genuine and ongoing challenge for options traders. Unfortunately, many novice options traders tend to be unaware of the time decay factor until it is too late. Traders can easily overlook time decay because its effect on option prices are not immediate.

    Time decay is most noticeable in shorter-term options, although the impact of time decay is present in all possibilities. This helps explain why many seasoned options traders prefer to sell rather than buy it. On the other hand, time decays is constantly working against those who hold long positions, requiring them to continually adjust their strategies to avoid getting caught with losses due to excessive time decay. It can be thought of as the cost of carrying a long position in an option over time. The longer an option is held, the greater the degree of time decay that will occur.

    Always remember, time decay works in favor of short-term option sellers and against longs.

    How Does Time Decay Affect Options Pricing?

    Time decay is the most critical determinant of option prices. A change in the price of an option due to a change in the price of its underlying security is called intrinsic value. An option's time premium is the amount by which its cost exceeds its intrinsic value, and it is almost always negative (i.e., the time premium portion of an option's price is always below zero). This means that an option will lose some of its time premium as it approaches expiration.

    In fact, time decay becomes more rapid as an option nears expiration; for example, an at-the-money call option with 30 days until expiration will lose all of its extrinsic value in only two weeks (and one day). The effect becomes so pronounced that options with only a few days until expiration are often worthless: they have no extrinsic value because they are already very close to being intrinsically worthless.

    Prices change as traders and investors gain and lose confidence in whether certain events will occur in the stock market. Or if they believe it makes more sense to either hedge their positions or take profit on existing ones instead of letting these positions run their entire course.

    This means the time value portion of an option's premium is eroded by time decay, increasing its intrinsic value. The effect of time decay is most significant in the last month before expiration since an option has a more extrinsic value that its passage can erode.

    For most options, the passage of time hurts their values. As an opportunity gets closer and closer to its expiration date, it becomes less valuable. This is mainly because of two reasons. First, the options have less time to go until it expires. Second, the more an option is in-the-money (ITM), the more significant influence time decay has on its price; that is, time decay accelerates for ITM options, so it does little good to extend your holding period for these contracts unless you have a specific strategy in mind.

    The effects of both these two factors are compounded, which leads to a rapidly falling value for the option. As a result, the rate at which an options value declines accelerates as it approaches expiry. This means that there is more risk associated with holding onto your trade than when you initially opened your position.

    Overall, a basic understanding of time decay helps explain some of the effects during periods of high volatility and other market conditions that can cause a sharp drop in implied volatility.

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