Options’ Time Decay Factor: How it works on value of Options

Although there are many ways to trade, almost every trader at least THINKS about the possibility of trading options.Recall the old adage, “Trading is not risky, only untrained traders are risky!”

This is no more true anywhere than in the area of options. The reason: they are a bit tricky!

Having already enumerated the various main components of options, I’ll now start a SERIES of detailing these so called ‘derivatives.’ 

Option feature: time decay – three statements 

They called derivatives because they’re not stock, but DERIVE their value, at least partially, from the movement of stock.

Statement #1 – The main difference between stock and options is that the value of options can decay over time.

Example: If you bought 100 shares of a stock valued at $30, you would have ownership of an asset worth $3000. If the price of the stock went up, you would make money;if it went down, you’d lose value in your asset. But, for the sake of the example, let’s say that it did go up for a while, and then go back down and one year later, the price was back to its original $30. You would STILL have $3,000 in assets in it.

On the other hand, suppose you spent $500 for a certain number of contracts (called lots) with an expiration date of 30 days later and attached to the price of the underlying, which is at $30. (As we’ll see, they ALL have expiration dates.) At the end of that time, regardless of the price of the underlying — it might be higher, lower or the same – your options contract could be ZERO! Gone! Totally evaporated! This is because it ‘decayed’ to nothing during that time.

In other words, although the option’s value was ‘derived’ from the value of the stock, there were other factors and other dynamics that came into play and these overrode the straight one-on-one value that a new trader might expect.

When a stock offers options, those contracts or offered in various lengths of time and at various possible prices of the stock, then referred to as the ‘underlying.’ The prices are display on a table known as the ‘options chain.’

The options chain shows the decay rates of the various options in a structured, month-by-month format. Also, even though it’s not specifically stated on the chain itself, it’s implied that if one BUYS the option, he is PAYING for the time decay and if one SELLS the options, he is MAKING money on the time decay. Much more on this later…..

Statement #2 – To further complicate matters with reference to this first characteristic of options – time decay – the RATE of decay in the value of the option varies depending on how far away the expiration date is and other factors, e.g., the movement of implied volatility which will be discussed in future issues.

Statement #3 – Finally, remember that the value of any option, just like the value of the underlying, is constantly changing. There are many factors involved, but just know that the value and the amount of time decay and the rate that it’s changing is different right now then it was 5 minutes ago!

It, like everything else in the market, is NOT a structured movement, with straight lines and 90 degree angles. It’s a very fluid sponge that moves and transforms with the emotions of the trading herd (all the people in the market).

So much for time decay for the moment…. Next we’ll take a wider look at how the options value is calculated.