Time Decay with Options

When one buys an option, one is buying the ability to buy or sell a lot of a security at a certain price at a certain point in the future. The price will be at a certain level when the option is bought, and the idea is that, if one is speculating on it, that the price will move enough in the direction that the purchaser hopes such that it will be worth more later.

With hedging, one is instead looking to buy a certain amount of protection, but the idea is the same basically, that if the value of the option increases enough over a given period of time, it will become valuable.

The difference is that with hedging options, the purchaser does not necessarily want it to become valuable, although if that does happen, the gains from the option trade will offset the losses of a security or another option, perhaps one that has been sold or another one that was bought.

Whenever we buy an option, we are paying a premium over and above the present value of the option which compensates the seller for taking the risk that it may increase in value by a certain amount over the time left until the option expires.

If a certain asset is trading at $50 and you want to buy a call option which starts paying off at $55 for instance, the strike price of the option, you will have to pay for this privilege of course. The price you pay is the cost of the option itself, what you paid for the right to be able to buy it at the strike price regardless of how much higher it goes.

The more time it has to move up, the more it will tend to cost you for the option in terms of the purchase price, the premium. It stands to reason that the longer you have for this to happen, the longer you can wait for it without the waiting costing you anything more, the more risk to the seller and the more potential benefit for you, and the higher the cost to buy it.

The factor of time is certainly not the only factor in options pricing, as this takes into account several factors that also determine how far the price of the underlying asset may move in your favor, but time is certainly one of the main factors.

How Time Decays the Value of Options

If you buy an option today, its price tomorrow will be influenced by a number of factors, including and most notably any price movements that may have occurred over that day. If the price has gone up enough, the price of the option will generally go up as well in tandem, but not in the same proportion.

The reason why not is that with each day that passes, the length of time that the option has left is reduced, and this reduction also reduces the value of the option. If the price does not change over our one day that has passed, the option will be worth less, since it now has one less day to move toward our goal.

As we move closer and closer to expiration, the effect of this loss of value as time passes, called time decay, becomes more prominent. If we imagine that we have two days left, another day passes, and we now are down to just one, the amount of time has been cut in half.

Earlier on in the contract, this one day’s passing has less of an effect because it represents a much smaller percentage of the time left. If you buy an option that runs for a year, and a day passes, you’ve only reduced the time period by 1/365, as opposed to1/2 moving from two days to one.

Time Decay in Action

The phenomenon of time decay is by no means a simple formula, and especially given the other things that also influence options pricing, this isn’t particularly an easy task for traders to account for, and this does lead to mistakes being made by them.

The option price has to move enough in a positive direction to keep the price stable, all other things being equal, and when it moves in the opposite direction it loses both the amount from the price movement plus the amount from the time decay.

There are options traders who do not account for time decay enough, and while time decay is expressed not simply like this but in combination with other things such as implied volatility, we need to be at least aware of its effects to have any sort of understanding of options.

Everything else that goes into options pricing is based upon our best guess of how the price of the asset will likely move, just like trading itself is, but we do know one thing for sure and that’s the less time you have for these things to happen, the less movement we are likely to see on average.

If a trader is speculating on options, this is going to make the velocity of price movements more important, and while velocity matters with other forms of trading as well, meaning more profits being made faster, it is particularly important to trading options.

Long term investors don’t care about velocity at all, as if you’re in a position for the long haul you’re only really interested in where the price will be years or decades from now, not how fast it moves up during any given time period.

Options traders are actually trading velocity itself, due to the time limitations involved, and to be successful in trading options actually requires a certain amount of velocity, over and above what the sellers of the options have priced into them.

When in a trade, after a price movement in their direction, the question they usually ask is whether it will keep going up or perhaps reverse the trend. Options traders need to wonder not whether it will still keep going up but whether it will still go up at the same pace or perhaps move up more slowly, and more slowly may not be fast enough to keep up with the time decay effect and other factors that may depreciate the value of the option.

Options traders employ many different trading styles, and the majority of options do not get exercised by anyone, let alone the traders who hold them at any given point in time. Since options are traded on exchanges, one may exit one’s position at any time, and the goal of many traders is to time these entries and exits according to trends, although these trends are certainly influenced by concerns of time and velocity.

Other Factors Affecting Time Decay

One of the notable permutations of time decay is that the further out of the money an option is, the more it will decay over time as a percentage of its value, due to how far it has to go in order to be in the money and how time has a more pronounced effect on this. Options in the money or close to it do decay as well, but at a lesser rate.

This is one of the things that makes out of the money, and especially well out of the money options not such a great idea in a lot of cases. The decline with out of the money options is not linear either, and is especially pronounced as the option nears expiration, particularly when an option starts to lose a realistic expectation of expiring out of the money and therefore close to worthless.

You cannot look at time decay without looking at implied volatility, and they go hand in hand, although it’s important to understand the effects of each separately. We know that time decay will always be present, but how much it decays the value of options is also dependent upon how volatile the price of the asset is expected to be.

Assets with high implied volatility can move faster than ones with lower implied volatility, therefore time is going to be less of a concern with things that can be expected to move faster, with more velocity, than those which can be expected to be less volatile.

There is more to this than just looking at the asset though, as we also need to look at the influences of the market in general, especially with stock options. If the market is crashing for instance, implied volatility can go through the roof, but more so with more volatile stocks than others of course.

If options traders do not pay enough attention to market conditions, as many don’t, they aren’t really going to have anywhere as good of an idea of the potential for their trades, and this is something that options sellers do pay more attention to, although sometimes not even enough.

Individual components drive indexes, but indexes or what we could call overall market conditions can at times drive individual components like nothing else, especially in more volatile conditions. Even in tamer market conditions, the trend of the market will still matter, as more or less money gets put in or taken out of the market during the life of the option.

Underlying Assets Do Not Really Decay Much

Taking positions in the underlying assets, whether this be with securities such as stocks, bonds, or currency, or derivatives such as futures, really don’t have much decay at all, and certainly nothing like options do.

The only real decay present in an investment is the cost of carry if you are borrowing money to own them, and in this case we need to make enough to cover these costs before we break even.

Time does matter as well with all forms of trading, and this is why we look at things like annual return on investment. There is no time decay in other forms of trading though, and when we pay a premium for time, we must assess whether this is really worth it for us.

Many people, for instance, focus on the much higher rates of return that options may deliver, but this does come at a price, as well as a cost in risk. More than anything, the problem with options, their potential downside, is expressed in terms of time, where in this case time is indeed money.

Options presume a certain movement over time, or at least are set up to tolerate such a magnitude in movement, and one profits from speculation on them by seeing the actual price movement exceed these predictions.

Knowing that something will go up or down by a decent amount to make it tradable, riding the trends that emerge, and knowing that something will both trend and trend enough, are two different tasks. Betting on both the direction and the magnitude of price changes, which options trading requires, is certainly the more challenging task than just betting on the direction essentially.

Those who seek to trade options need to give careful thought to not only their potential profitability for them, but whether they would be better served trading the assets themselves, and often the correct approach is to trade securities that do not have such strict time restraints and issues of magnitude.