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!.
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Disclaimer: Options involve a high degree of risk and are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially significant losses. Please read Characteristics and Risks of Standardized Options before deciding to invest in options: Here
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