Options and Time Decay – What to Know!
At the most basic level, an equity option is a contract that gives the buyer the right (but not an obligation!) to either buy or sell an underlying stock at a specified date and with a specified price. This makes the price of the stock one of the most important factors of the value of the option, as it is the largest and most obvious factor that affects whether the option will finish with value (“in-the-money”) or worthless (“out-of-the-money) at the expiration date. Time, however, is an often overlooked and important factor when determining the value of an option.
Let’s take the example of a hypothetical 100 strike ABC call option that expires in two days with the underlying stock trading at 90. An increase in ABC’s stock price certainly could increase the value of the 100 call, but if the move isn’t drastic enough, the likelihood that the stock would finish over 100 decreases rapidly as the expiration date approached. The value attributed to the time component of the option – often called “time value” or “extrinsic value” – approaches 0 as the expiration date nears, meaning that if the stock doesn’t rise above the strike price the option still could lose value even as the stock price goes up.
For near-dated options, it’s important to factor time into the equation when putting on a trade. Options with a strike price that is near the stock price (or already in-the-money) typically have less exposure to time value and for cases where the option is
already in-the-money, actually benefit from the decrease in time value.
The important takeaway – the stock price isn’t the only factor when evaluating options trades, always remember to take time value into consideration when trading options!.
Alec Baum
CEO & CoFounder
© 2024 Optionality. All rights reserved.
Disclaimer: Equities, equities options, and commodity futures products and services are offered by Lightspeed Financial Services Group LLC (Member FINRA, NFA and SIPC). Lightspeed Financial Services Group LLC’s SIPC coverage is available only for securities, and for cash held in connection with the purchase or sale of securities, in equities and equities options accounts. You may check the background of Lightspeed Financial Services Group LLC on FINRA’s BrokerCheck.
All investments involve risk and past performance of any security does not guarantee future results or returns. Please refer to our fee schedule for a complete listing of relevant charges. System response, trade executions and account access may be affected by market conditions, system performance, quote delays and other factors. The risk of loss in electronic trading can be substantial. This is not an offer or solicitation in any jurisdiction where we are not authorized to do business. Optionality makes no guarantee as to the currency, accuracy, or quality of information published and/or archived on the platform, nor will Optionality accept any responsibility for other organizations, businesses, and private persons that provide information on this platform. All information on the platform regarding products and services provided by Optionality is subject to change without notice. Optionality is not responsible for misprints, out of date information, or errors. Optionality does not provide any financial or investment advice.
Terms: “call spread,” “Expires” “positions” “71% positive” (pie chart) “positive snippets” and “negative snippets.”
“*Pre-packaged spreads are option spreads formed by our algorithm and offered as a package.”
“A bull call spread is an options trading strategy designed to benefit from a stock’s limited increase in price. The strategy uses two call options to create a range consisting of a lower strike price and an upper strike price. The bullish call spread helps to limit losses of owning stock, but it also caps the gains.”
“An expiration date in derivatives is the last day that derivative contracts, such as options or futures, are valid. On or before this day, investors will have already decided what to do with their expiring position.”
“Positive and Negative Snippets are a proprietary output from our partner Stocksnips that aggregated the total amount of media mentions of a certain stock and takes the percentage of those that are positive or negative, as in the example shown above referencing 71% positive”
“As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is right for you based on your investment objectives, risk tolerance, and financial situation.” · “0.50 per contract”
*Options trading involves a high degree of risk and may involve total loss of investment. Options spreads, specifically, offer the benefit of projected maximum gain and loss positions (defined above as “defined risk trades” and “defined outcomes”, but in rare situations may result in gain/loss in excess of the projected cap. Optionality has several mechanisms to greatly reduce these occurrences, but we cannot guarantee they will never happen. For more information on options, Please read Characteristics and Risks of Standardized Options before deciding to invest in options.