Accounting for Option Time Decay

It is a common mistake of novice option traders to believe that if the stock goes up in price, then the options written on that stock will necessarily rise with it. While it is common for the two to rise and fall in tandem, this is not always the case.

Elements of an Option Premium

The premium you pay to buy an option is based on two facets. First, part of the option premium is based upon the current difference between the strike price and the stock price. If the stock price is $20, call options with a strike price of $17.50 should sell for no less than $2.50. At any price less than $2.50, the options could be exercised for a profit, and there isn't a trader in the world who would write options on which they lose money immediately.

The second part of the option premium hinges on the correlation between risk and time. Options with long dated expiration have significantly higher premiums than those sold with front month expiration dates. This has to do with the fact that significantly more can happen in a year than can happen in a month, and the underwriter has to price in the risk that the stock will rise beyond the premium price, thus costing the underwriter serious potential profits.

Option Time Decay

It is a fact that as an option approaches expiration, the value of the difference in price between the strike price and the current stock price (otherwise known as the premium) will slowly disappear. This is because of the limited amount of time a stock has to make a move.

In option trading, time decay is represented by theta, which represents how much value the option will lose each day it approaches its expiration date. Theta, which is also known as extrinsic value, option time premium, or time value, will always be negative, as the value of an option erodes each and every day.

Option time decay is best shown at both extremes. Imagine if someone offered to sell you stock options on WalMart stock that were set to expire in the year 2100. Would you buy them? You would unlikely make the purchase because of the sheer number of possibilities that can happen in that amount of time. Also, the seller would have to price in their opportunity cost of holding the stock for such a long period of time.

Now imagine if someone offered to sell you options on Microsoft stock with a strike price of $25 when the stock is currently trading at $24. He offers you a premium of $.50, and expiration is tomorrow. Would you buy them? You would likely not, as Microsoft would have to rise more than 6% in order for you to break even, and the stock would have to do so in an extremely limited amount of time.

You might, however, pay a nickel per share in option time premium, with the assumption that Microsoft will release earnings at opening bell tomorrow, since the risk (limited amount of time) is outweighed by the potential reward (huge returns if Microsoft reports strong earnings). In this case, Microsoft does have the potential to reach $25.50 (breakeven point) on strong earnings, and your risk is small (only $.05 per share) if earnings come under estimates.

Time decay, or theta, is a critical part of options trading, determining whether or not your trade will be profitable.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
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