Few things are certain in life. But as the old saying goes, there is nothing quite so certain as “death and taxes.” As an options trader, I would enthusiastically add option time decay to that list.
Options offer traders and investors more leverage and risk mitigation than just purchasing shares outright. For example, if I were to purchase 100 shares of a stock at $100 per share, my total capital outlay would be $10,000. Options give us the right to buy or sell at a certain price for a pre-determined length of time. I could control that same 100 shares by purchasing an At-the-Money call with a $100 strike price with 90 days to expiration for perhaps $6 per share, or $600 total capital outlay. That’s powerful leverage. My downside risk is also limited to the amount I paid for the option, in this example, $6 per share. Compare that to purchasing the stock where my risk is, in theory, as much as $100 per share. (Although they’re relatively rare, “flash crashes” happen, companies can and do go bankrupt, get de-listed, etc.)
Since options give the holder the right to buy or sell at a specific price for a specific time period, they have a time value component right up until expiration. Included in the price of every option (put or call) is the cost of the time value remaining in the option. In comparison, the holding period for stock can be indefinite, and there is no risk of expiration, only market risk.
Intrinsic And Extrinsic Time Value
The price of an option comprises two parts – intrinsic and extrinsic (time) value. Intrinsic value is simply the difference between the underlying's market price and the option strike price. Extrinsic value is another term for the value of the time left in an option before it expires. When we buy an option, part or all of what we're paying for is the option's time value. The further away the option expires, the more time value will be worth. Prior to expiration, there will always be some time value. But there may or may not be any intrinsic value to an option. Options with no intrinsic value are referred to as Out-of-the-Money (OTM) options.
If you’re an option buyer with the right to buy or sell at a certain strike price, the “bad” news is options have a finite life – they expire. But for every option buyer, there is a counterparty. Option sellers are collecting a premium in exchange for taking on an obligation to either buy or sell shares at a certain price for a specific period of time. For option sellers, expiration marks the end of their commitment – so expiration is “great” news for them.
Time Decay
When we buy options, time decay works against us. For the holder of a long option, the option's time value will decrease a little day by day as expiration draws closer. As an asset, time value is like an ice cube, melting slowly at first and then rapidly until it has entirely melted away. This is not to say don't ever be a buyer of options. If we happen to be right about direction, duration, and magnitude, a long put or call option can generate a significant profit.
Option time value is measured by Theta Decay and is commonly estimated daily by the calculated Theta. Theta is one of the more valuable of the Option "Greeks" to make use of. Essentially, all trading platforms for options can be configured to show Theta as part of the option chain.
Is it possible for the time value to increase rather than decrease even though the calendar time to expiration is decreasing? Yes. It certainly can. Remember that the price put on time value is variable and determined by market forces. If the underlying stock becomes much more volatile than it had been, then the value for that time can increase, sometimes substantially. If the underlying has been very volatile and becomes less so, then the time value can shrink.
To Sell Or Buy Options?
We can significantly turn the odds in our favor by being the seller of options. In that case, we're selling any intrinsic value (which would be $0 in the case of an Out-of-the-Money option) along with some portion of time value. Intrinsic value will go up or down with the price of the underlying. But in the end, as expiration gets close, the remaining time value will always approach $0 regardless of volatility. That we can literally "take to the bank."
There's a well-known quote from Warren Buffett: "If you don't find a way to make money while you sleep, you will work until you die." Buffett is also famous for being a seller – not a buyer – of option premium. Like Buffett, I too like to make money while I sleep.