Options - Time Decay
Options are unique in that they have a fixed expiry date after which time they can no longer trade. Options are a wasting asset. They will lose value as time passes. If you are relying on the underlying market to move in your favour while holding an option contract, it must do so before the expiry date of the option. If it finishes out of the money (below the exercise price for a call option and above the exercise price for a put option), then the option will expire worthless.
Example of holding a call option in gold.
- Gold is currently trading at $630 per ounce
- You are currently holding a gold call option that has an exercise price of 650 and will expire in one month.
Figure 1 shows that at expiry of the option, the price of gold needs to be higher than the exercise price in order for the option to be worth anything.
However, even though currently the price of gold is less than the exercise price, the option will continue to have value because there is still one month left in the life of the option. There is time for gold to stage a rally and possibly trade above the exercise price of 650. This value that the option has, even though it is trading below the exercise price, is known as its time value.
The more time an option has before expiry, generally the more it will be worth as there will be more time for the market to make a favourable move. An August gold call option with an exercise price of $630 will be worth more than a June gold call option with the same exercise price.
The closer to expiry an option gets, the less chance there is for the market to make a move in your favour; therefore, its value will begin to ‘decay’ (lose value). Options that are at the money (closest to the current market price) have the greatest rate of time decay. The following diagram graphically displays how the process of time decay works.
Figure 2 shows how the time decay of an option accelerates as it approaches expiry. In particular, notice that in the last 30 days before the expiry of the option how time decay is most rapid. This means that an option will lose more time value in the last 30 days before expiry than at any other time during the life of the option.
Buying out-of-the-money options (long way from current market price) with less than 30 days to expiry will require substantial moves in the underlying market in order to become profitable. More often than not, markets will spend more time in a trading range than trending. Most times these out-of-the-money-options will expire worthless. Look to take advantage of this fact by writing (selling) these options as part of an overall strategy when time decay is most pronounced.
From the above analysis, it may become clear that option buyers have the disadvantage of having time decay working against them. If time decay works against buyers of options, then it stands to reason that it must be working in favour of option writers (sellers).
This is one of the biggest advantages that option writers (sellers) have over option buyers. It is the main reason why writing options (especially out of the money options), is such a high-probability trading technique, favoured by professional option traders.
Does this mean I should not buy options at all?
No, it does not. It simply means that you would be well advised to follow a few rules to minimise the adverse effects of time decay on bought options. They include:
- Buy options with more than two months to expiry.
- When to buy short dated options.
- Buy options when volatility is low.
- Buy closer-to-the-money options instead of out-of-the-money options.
- Combine buying options with writing (selling) options
- Always have profit targets when buying options
Options decay rapidly in the last two months before they expire, particularly in the last month (see figure 2). By buying options with more than two months to expiry option decay will be less pronounced while you wait for the market to move in your favour. Ideally you should buy options with 3 – 6 months to expiry to give yourself sufficient time for the trade to work in your favour. The market has a way of taking its own sweet time about making a move that you expected should already have happened last week! The wasting effect of time decay will be much less for options with 3 – 6 months to expiry. If the move doesn’t happen as you anticipated then you can close the trade before it gets to the period where time decay is most pronounced.
Only consider buying options with less than two months to expiry if you a certain of the timing of the move. For example if you are a break trader and the market has broken above or below resistance or support then short term options can provide a low risk way of entering the market with a leveraged position. In fact massive profits can be made by using very short term options (2 weeks or under). On big breaks short term options can go from being worth less than $100 to thousands of dollars within a few days. However if the market does not move in your favour immediately, and in a fairly big way, these options will more than likely expire worthless.
The value of options are affected dramatically by the volatility of the market. The combination of paying too much for an option, and time decay, can considerably lower your odds of success for a profitable trade.
Out-of-the-money options (exercise price far away from the current market price) will lose their value due to time decay more quickly than options that are closer to the current market price, when options are close to expiry.
Known as option spreads this would involve buying an at the money or close to the money option and at the same time selling (writing) an out of the money option. As well as making the trade cheaper you can benefit from time decay in writing overpriced options a long way from the current market price.
If trading more than one option, sell half of your position if you double your money. This will effectively leave you with a ‘free trade’ on the rest of your position and not leave you out of pocket if the market then goes against you before the option expires.
- Use option-writing (selling) strategies where appropriate, as these trades will have the highest probability of success.
- Write (sell) options with six weeks or less to expiry. Time decay really starts eating into the value of options after this time.
- Write (sell) options using an exercise price a long way from the current market price when volatility is high.
Time Decay Summary
- Options have a fixed expiry date after which they can no longer trade.
- Options are a ‘wasting’ asset.
- The more time an option has to expiry, the more ‘time value’ it will have.
- Time decay accelerates in the last 30 days before expiry.
- Time decay works in favour of option writers (sellers) and against option buyers.