Option time decay
By Simon Gleadall, CEO of Volcube.
What is option time decay?
Having the option to do something is a more valuable thing, the longer the option is valid. If you have the option to use my umbrella for the next 5 minutes, this is probably pretty worthless it is not currently raining. But having the option to use my umbrella could be valuable if the option is valid for the whole year.
With financial options, the situation is really the same. An option to do trade something at a certain price is, other things being equal, more valuable, the longer the option is valid. So for options with a fixed expiration date, as time passes, their value in terms of their optionality will decline. For example, a call option that gives us the opportunity to buy the underlying product for say $100 at any time over the next 12 months, is out-of-the-money if the underlying is trading at say $80. But the option may still have value because there could be a chance that the underlying will rally over the next 12 months to be worth more than $100. As each day passes though, this ‘optionality’ declines. Eventually the option will only have 5 minutes until it expires. At this point, if the underlying is still trading well below $100, the option’s value is probably zero. So over the 12 month period, the option’s value will have been decaying away. This is option time decay.
How different options decay over time in different ways
Not all options decay in the same way. For example, an option that has a very long time until it expires, may experience very little time decay on a day-to-day basis. This is because, relative to the entire length of the option’s life, losing one day makes little difference to the optionality. But for an option that is about to expire, one day passing can be a huge proportion of its lifespan. So out-of-the-money options that are close to expiration will experience relatively large amounts of time decay.
Another distinction is between options that have very high implied volatility levels and those with low vol levels. The higher the implied vol, the higher the option value, other things being equal. But since all out-of-the-money options must expire worthless, the higher vol options in a sense have ‘further to fall’. Their value must fall from a higher price to zero than an equivalent option with lower implied vol. This is just another way of saying that higher vol options will experience higher option time decay than lower vol options, other things being equal.
A third important factor is the relative strike of the option compared to the spot price. An at-the-money option will typically experience the highest time decay of any option on the same underlying with the same expiration. This is because at-the-money options have the highest optionality. They have the highest extrinsic value of any option and remember it is the extrinsic value which represents the optionality of an option.
How option traders manage option time decay
Option time decay is one of the few certainties that affect options. The optionality of an option will eventually decay to zero at expiration. This has implications for the owner of options whose ‘asset’ will decline in value, other things being equal. The short option player hopes to capture the time decay as a source of profit. How then does the long option player mitigate the effect of option time decay?
For those trading options directionally, it is a matter of expecting the profits from the changes in the spot price to out-weigh the time decay losses. For those trading options as a volatility play, it is more likely to be a matter of gamma hedging and gamma trading to cover the time decay premium.
The actual $ value of time decay is represented by the option Greek theta. You can learn more about theta in this article.
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