A question that often crosses the minds of traders is whether or not options decay, and how quickly they decay. But before that, let’s take a look at what ‘decay’ means in the first place.
What does it mean if an option decays?
If you’re new to options trading UK, you might be wondering what it means if an option decays. An option’s premium comprises two parts:
• Intrinsic value: This is the amount by which the option is in the money, representing the contrast between the strike price and the current market price of the underlying security.
• Time value: This is the amount by which the option premium exceeds the intrinsic value and reflects the potential for it to become more valuable as it approaches expiration.
When an option gets closer to expiration, its time value starts to decay and accelerate. There is less time remaining for the underlying security to move enough to make a profit on the option. The amount of time until expiration is the primary factor affecting an option’s premium, so the time value of the option reduces as the expiration approaches.
This phenomenon is known as time decay or theta decay. Time decay can significantly impact options trading, so it’s essential to understand how it works.
How does time decay work?
As mentioned above, time decay accelerates as an option approaches its expiration date. The speed of this acceleration depends on many factors, including the level of implied volatility and the amount of time remaining until expiration.
Implied volatility measures market expectations for future price movements of the underlying security, affecting the premium of both calls and similarly put options. When implied volatility is high, option premiums will also be higher because there is more potential for price movements.
When implied volatility is low, option premiums will be lower as well. There is less potential for price movements, and Theta decay will be more significant when implied volatility is low because there is less time value to lose.
Amount of time remaining
The amount of time remaining until expiration also affects the rate of time decay. The closer it gets to expiration, the faster it will lose its time value. It is due to a simple principle: the longer an option has until it expires, the greater the chance it will become profitable.
This principle can be demonstrated with a simple example. Consider a call option with a strike price of £50 and an expiration date of one month. Assume that the underlying security is currently trading at £48. The option has an intrinsic value of £2, but it has a time value because it still has a month until expiration.
Now consider the same option with only two days until expiration. The underlying security is still trading at £48. The option still has an intrinsic value of £2, but its time value has decreased because less time remains for the underlying security to move enough to make a profit on the option. Theta decay is the loss of this time value as an option approaches its expiration date.
Theta decay can have a significant impact on options trading strategies. It’s essential to be aware of how time decay works and how it can affect your trades. There are a few ways to trade options to take advantage of theta decay.
One is to sell options that are close to expiration, and it is known as selling options ‘at the money’. When you sell an option, you accumulate the premium and hope that the option expires worthless so you can keep the entire premium.
Another way to trade options is to buy options far from expiration. It is known as buying options ‘out of the money’. When you buy an option, you pay the premium and hope that the underlying security moves enough so that you can sell the option at a profit. Theta decay will work in your favour when you buy options out of the money because it will erode its time value, making it cheaper to buy.
You can also use it to hedge your portfolio against time decay. It is known as a ‘delta neutral’ strategy. When you take a delta neutral position, you are buying and selling options so that the overall delta of your position is zero. It means that your position will not be affected by small movements in the underlying security.