With options trading, your time with each options contract has an endpoint, because call and put options come with expiration dates. When you take on long option positions, Father Time works against you because the options will decay, and that decay accelerates as you approach expiration.
While all options are at risk of decay, the impact is most apparent in out-of-the-money options. If the underlying stock can be bought at a lower price than the strike price of the call you own (for instance, if you hold a call option at the $35 strike that’s set to expire this month and the stock is trading at $33), then it is likely that your option will go out with no value.
Options are known as a “wasting asset,” which means that, by their nature, their value is set to decline over time. As the clock ticks away the life of the contract, there is less time for that trade to become profitable and, thus, its value dissipates at what feels like lightning speed.
Putting a Price on Time
This makes time seem very precious and very expensive. Sort of like a do-it-yourself car wash when the wash starts beeping to let you know to drop in another quarter for an additional 30 seconds. Only with options contracts, you can’t extend the expiration date beyond the third Friday of that contract’s expiration month!
The reverse is also true (at least, it feels that way) when you’re short a bunch of call or put options, which is why some folks will claim that the only way to make money with options is to sell them. When you are short options and the trade is going in your favor, the time decay of the option rushes into your account faster and faster as you approach expiration.
Time decay can be your friend when you’re not the one holding the option long, because someone else’s loss can translate into your gain. And it all can become addictive because the money comes in so quickly that you want time to speed by.
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When you sell in-the-money calls (i.e., those that you can exercise for a profit), these benefit from a drop in the stock price, as do out-of-the-money calls, which have even less likelihood of becoming profitable for the buyer before that approaching expiration date.
There were probably only a couple other times in your life that you wanted time to go quickly — during history class in high school, during a root canal or while watching your favorite football team be blown out in defeat. You can almost hear traders rejoicing on Fridays, knowing that two more days of time decay are going to make them richer over the weekend!
The reason why traders and investors who short option contracts want time to fly is because each passing day means there are fewer opportunities for that stock or index to rally (in the case of calls), or fall (in the case of puts) — thus, that’s why the decay curve for options accelerates as your trade approaches expiration.
Time Keeps on Slippin’ Into The Future
Before your eyes glaze over, it’s actually easy to imagine why this happens — even if you didn’t graduate at the top of your math or logic class.
Let’s examine what happens to expiring options that aren’t likely to become profitable by the end of the options contract.
For the sake of argument, let’s assume there are 10 days until your November option contract expires, but on two of those days, Saturday and Sunday, trading is closed. Ergo, in this example, there are actually only eight full trading days for the options — whether they are calls or puts — to finish in-the-money.
For example, let’s say we have a hypothetical at-the-money XYZ Corp. (XYZ) Nov 32.50 Call that is trading for 75 cents, while the XYZ Dec 32.50 Call is trading for $1.70.
That November call might look cheaper than the December call, but in eight trading days, every penny of those November calls will be exhausted because they will become worthless or turn into stock.
So the real cost of owning the XYZ Nov 32.50 Calls is $0.0625 per day. On the other hand, the XYZ Dec 32.50 Calls decay at just $0.0425 per day, or about 30% slower.
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The reason for the quick decay of the nearest-expiring option is simple: There’s only a set amount of time in which the trade can become profitable.
If the option is out-of-the-money, the time left for it to become profitable is limited and, thus, the chances of it becoming in-the-money are less likely. (Note that a call is out-of-the-money when its strike price is greater than the market value of the underlying stocks, and a put is out-of-the-money when the strike price is less than the current value of the underlying security.)
Discussions about time decay can be somewhat dull, but once you understand the principles behind why the near-term option decay is faster than the second- or third-month-out options, you have moved the odds further into your favor, which should always be your goal.
Is There Any Way to Save an Ailing Trade?
Projecting a time frame to purchase an option is very important.
If you believe that the option will work for you in the short term, then you can generally buy an option 30 to 90 days out (from expiration).
If you believe the option will become profitable in the medium term, you’d want to consider options that are three to nine months away from expiration.
And although options are designed to be short-term trades in nature, you can initiate a longer-term play (i.e., projecting out about nine-plus months, sometimes up to two or three years, depending on the option chain available for a particular stock) through Long-Term Equity Anticipation Securities, or LEAPs.
For a trade that isn’t going in your favor as expiration nears, it’s possible to try to turn the odds in your favor.
You can choose to exit the trade in a timely manner or to “roll” your option up, down, forward or back — meaning, you can replace your existing position with a new options play on that same security by choosing an earlier or later expiration date and/or a higher or lower strike price.
In this way, you have a real shot at transforming the “enemy” of time into an ally.
Jim Woods is a Senior Editor for OptionsZone.com. To learn more about him, read his bio here.
