>

Lesson 6: Time Decay

Time Decay, Time Decay in options

Time Decay, Time Decay in optionsWe have seen that one of the most important elements that affect the value of an option is the volatility. Now we see another element equally important, the time decay. The premium, we have seen can be influenced by several factors, it represents the price of an option and is comparable to an insurance premium. One of the most common analogies made for options is that they act like insurance policies, especially the premium concept.

Imagine that an option is like car insurance, for example against theft. Paying an insurance, that is a small part of the price of your car, you have the guarantee on the value: if someone should steal your car, the insurance will compensate you.

Now replace your car with stocks or ETFs or with a future, and you have exactly the operation of an option. A guarantee in case your investment does not go as planned. It is the main reason because the options have been created, to protect investment in the event of a loss. To have, precisely, a function of investment insurance.

We have seen that buying options can be very beneficial because it gives us the opportunity to buy or sell an underlying at a better price than the market price. If we are good at finding where an underlying can go, with the options, we will have a chance to earn far more than not working directly on the underlying.

Buying options, however, do not only have positive aspects, but there are also several elements that play against us. The first of these elements is the time. When we buy options, time is not our friend because every passing day takes a bit of value to our option. You can see the time decay of an option in figure 7 below.

Time Decay, options, how the time decay affects options

 

The closer we get to the expiring date and less time value will have an option. To indicate the time value is used a Greek called Theta. When you see this symbol θ (Theta) on your trading platform, its value will tell you how much time remains to that particular option.

Clarification. I am not forced to hold a purchased option until its expiry. I can resell it when I find it more appropriate, and I will explain it with an example.

eBay has a value of $ 35.50, and I decide to buy an option CALL strike $ 36.00 expiration two months (January 19, 2018) because I expect the stock will soon go up. The market asks me $ 0.80 for premium (so I will pay for my option $ 80.00). After a week eBay rose to $ 37.00, and for the same option I bought, now the market asks $ 1.50 of premium. I can still choose to keep my option a bit because I predict that eBay will still increase its value, or I can decide to sell it and cash out the $ 150.00 of premium with a net gain of $ 70.00 ($ 150.00 of the sold option minus $ 80.00 of the bought option).

The probability is a second element that plays against us in buying options. If I buy a CALL option, I will only earn if the underlying rises and even with strength. If it goes down, moves horizontally or rise, but not enough to attain at least the break-even level, I will lose the premium paid (or part of it). The same if I buy a PUT option, I will only gain if the underlying will fall below the break-even point. My probability of success is therefore 1:4, that is 25%.

We have therefore seen that by purchasing an option, in the face of a small premium paid we can make a big profit but time and probability are not on our side.

It does not mean that buying options is wrong, absolutely not. Buying options, however, are difficult to earn because this requires a lot of precision in identifying where an underlying can go and in what time. And, above all, it does not allow us to earn steadily over time: month after month, year after year.

As with stock, futures, commodities and so on, even with the options we can either buy them or sell them. And of the sale of options, I will start talking in the next article.

 

Related Post

Leave a Reply

Your email address will not be published. Required fields are marked *

Pin It on Pinterest