Option Time Decay - A Complete Guide to Theta!
Understanding time decay options don't have to be cumbersome anymore! From looking at the intrinsic value to the expiration date, there is much which will be explored within the article at hand.
Options are the most popular derivatives because they provide investors with the right to either buy or sell a stock at a certain value. Of course, this means that the option contract will also come with an expiration date; this signifies that before those options expire worthless, the holder must exercise them. If they do expire, then the likelihood is that it could cost a trader tremendous sums of money too.
Additionally, something to understand here is that multiple factors influence the trade mechanism. Options Traders will have to deal with ideas such as the underlying price of the current stock, and decisions such as whether the underlying security is worth keeping in the first place. Having said the above, let's continue our discussion regarding time decay by familiarizing ourselves with:
What is the Time Decay of an Option?
In essence, time decay can be described as the natural reduction in the market price of an option as it approaches its expiration dates. When time decay occurs, it leads to increasing an option's probability of expiring and that too out of the money. Therefore, as time decay leads to the erosion of price, options traders here have to be cautious. This is applicable for both short-term option sellers and long-term option sellers.
So, in a nutshell, when an option's price is reduced over time - meaning when its specified price is facing a decrease, and that too up to the point at which its expiration draws closer, time decay will set in. Now, while many traders are familiar with the concept of volatility and time remaining until expiration, some are not, which may cost them in the long run. In this situation, our advice is that if you are engaging in an option trade, you should conduct some legwork and ensure that you have the knowledge you need to get started.
Dissecting the Calculation behind the Time Decay and how it Works!
Calculating time decay in an options contract isn't hard; when the stock price is subtracted from the strike price of the underlying security and then divided by the number of days until the option nears expiration, this will give you the time decay. Time decay works by keeping in mind how option prices as determined. Also called Theta, this signifies that options in the money or at the money are worth more than those out of the money. Moreover, time decay also places a time value on underlying security - the further away from its expiration date, the more the chances are of the company earning greater profit margins.
Understanding A Few Vital Terminologies:
Intrinsic Value and Extrinsic Value:
An intrinsic value reflects the value of a given option's price today. This showcases whether the price is in the money option and therefore profitable or not. An extrinsic value of any option will rise as volatility increases; it is the difference between the time premium portion of the Options contract and its intrinsic price (also known as the strike price).
When a call option expires, this means that the strike price is less in comparison to the underlying security. Now, because this expires in the money, the trader can earn higher amounts of potential profits. On the other hand, if the time to expiration has occurred in the put option, then the opposite will hold, which is that the strike price will be greater than the underlying security and its price.
The Strike Price and Implied Volatility:
Whether you want to consider buying options or selling securities, a strike price is needed. As expiration approaches, you have to decide whether it is viable to get rid of the security or purchase it by considering the options prices, which in this case, is the strike price.
On the other hand, implied volatility measures the stock's volatility over an option's life. This comes in handy for an option buyer and seller to forecast their potential trading profit or losses, for that matter.
Understanding Time Decay's Impact on Traders:
The major effect that time decay has in terms of trading, especially on its traders, is that any extrinsic value of the contracts will gradually diminish. If there are, for instance, some traders who buy only calls and puts, and that too with the view that they will be holding them until the date of expiration, then they are somewhat on the bright side. This is because though the extrinsic value will be eroded by time decay, the underlying security will nonetheless be in a good position to make up for any loss. But, this doesn't apply to traders planning to close their position before expiration. Here, the traders are generally at the better end of the bargain, and all that they may have to bear in mind is that the intrinsic value of any options purchased has to be greater than the effect of time decay on it.
A simple example is that if the intrinsic value rose by $1, but time decay hits $1.50, you will be in a bad position. Therefore, the viable option is that you should wait for the price of the contract you wish to buy to go up before selling them. But, even if you do the above, it doesn't guarantee that you will be earning heftily on the asset. The best bet here is understanding time decay, how it works, and your trading strategy. The beauty of time decay is that it can work to your advantage; as mentioned above, when the extrinsic value erodes, you will benefit from offsetting that part in the first place by either buying options or writing options simultaneously. A hypothetical example here is that you could purchase an underlying asset with intrinsic value on a particular stock and, at the same time, write out another asset that has no value on the same stock.
A thing to note is that the contracts you have bought could yield you high profits if the time decay works in your favor. There is no right or wrong way of conducting trade here; what mainly takes precedence is what you are planning to buy or sell the asset if any, and your end goal. The examples mentioned above showcase the basic principle of time decay and how it works. But utilizing it to either your benefit or disadvantage depends solely on you at the end of the day. You need to plan how you wish to proceed forward with your trade and how favorable the prospects are.
What are the Benefits of the Options Contracts?
There are multiple benefits that you can reap with the help of these contracts. For instance, you can firstly:
Be Subjected To Lower Risk:
The risk attached to investing in Options Contract is less if you know how to use them properly in the first place. For example, if your date of expiry will occur, you can benefit from earning a greater premium on them later on in your underlying stock. Nonetheless, it all falls down to you and how you are conducting your trading in the first place. If the options strategy you have concocted is feasible in your opinion, then you need to have faith in yourself, and let it go with the flow. In the end, it depends on you!
Gives rise to tremendous Profit Potential:
You can earn considerably well here if you know how to go about certain things properly. For starters, there is a minimal investment, and secondly, what matters is being mindful of time decay, the expiration date, and when you are willing to make the trade in the first place. Once such questions are ascertained, it will become a little easier for you to curate a trading strategy that works well.
Paves a pathway to combine with Alternate Trading Strategies:
The beauty of an Options Contract is that you don't need to have a company name tag by your side to get in, and neither does it require you to be an expert in the field. As long as you have somewhat knowledge, are passionate about what you're doing, and most importantly, how it is being done, you are good to go. This falls on the level of determination that you have and how clearly you have understood the way certain things such as the time decay, call option, and time value work. Once this is brushed up, you can easily combine your knowledge with alternate strategies, which will help you keep the volatility levels in check and much more.
The Bottom Line: An Options Contract Is A Wonderful Way To Trade!
The key takeaway here is that time decay can heavily impact the underlying price, but the further the prices are from the expiration date, the less impacted they are. Additionally, it also calls on you to have some knowledge regarding the idea of time premium, extrinsic value, time value, and intrinsic value. Lastly, a major thing to keep under consideration is that any out-of-the-money options are more heavily influenced by time decay when put parallel with in-the-money options. Having said the above, we advise that you conduct your research too and see an example or two of how trading is conducted in options contracts. This kind of exposure and knowledge will come in handy when you set your foot in this field.
Note: Market Moves LLC is not your financial advisor, and neither do we claim even to be one. Like you, we are a bunch of individuals who are enticed into the world of trading and options. Therefore, whatever we say is solely based on our first-hand experience and does not guarantee the same kind of results for you. This is owing to multiple factors that impact trading in the first place, and they vary based on individual to individual.
A few questions that our audience tends to ask us regarding time decay are:
Does the Time Value of an Options Contract matter?
The rationale behind the financial planning of an option seller and buyer is quite simple - if there is more time until expiration takes place, then the time value of the option at hand will also be greater. The thing to denote is that investors will be willing to invest when they know that the option's premium which they will be receiving is high. If this doesn't seem to be the case with the passage of time, then the likelihood is that they will move on to another contract, which delivers more favorable results.
What happens when Time Decay Accelerates?
If there is a greater time decay during an options trade, then this means that the trader has less time to earn a profit. In this case, the most likely investment advice is that one should necessarily reflect on whether the security is worth it. If it isn't, and you are only bound to lose money, then it is better to let go of this asset instead.
Does an Option's price matter?
During options contract trading, you have to look at the option's price because it can help you make investment decisions. Options involve risk, but that doesn't mean you can't make the most out of your investment. If you are careful and know the basics, such as the out-of-the-money, at-the-money options, and when the time decay is bound to set in, you are good to go!
What are Shorter Dated Options and Longer-Dated Options Contracts?
There are only a few days for you to get rid of the option before the expiration sets in in the former. Whereas, in the latter, the remaining time until expiration is greater, and you can sell it at any time as pleases you.
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