Dan Passarelli is an author and the founder of Market Taker Mentoring LLC, the home of personalized, one-on-one options mentoring.
Got a plush pad? You probably pay big rent. That’s how it works. The better something is, the more you pay to rent it. That’s even how it works with options trading.
Two features that combined make options a fantastic trading vehicle are leverage and limited risk. If a trader buys a call, he can only lose what he pays for it; but he stands to potentially make so much more. In fact, long calls have unlimited profit potential. Sounds great, right? Well, there is a catch.
Long options are subject to time decay. Time decay means that as each day passes, the option gets worth a little less. Time decay cuts into profits, or adds to losses. For some traders, time decay is a complete turn off to buying options. But, for what you get, sometimes it is justified.
I prefer to think of it as rent for the limited-risk/leverage benefit. Each day a trader holds a long option he gets the benefit of safety to the downside and potentially big percentage profits to the upside. Effectively, volatility is on the long-option trader’s side. Traders pay for this volatility benefit with “rent”, or more accurately, time decay.
Next time you’re considering what to trade, think of time decay as renting a beneficial asset. Though, the benefit isn’t always worth the cost, on many occasions it is a reasonable cost of doing business.
Dan Passarelli of MarketTaker.com writes the Market Taker Edge options newsletter. Dan has more than 17 years’ experience in the options industry as a market maker, Options Institute instructor and author of “Trading Option Greeks.”