Editor’s Note: Welcome to the relentless march of time, where your options contracts age like milk, not wine. That pesky phenomenon called “time decay” ensures that as expiration creeps closer, your options lose value faster than a streaming service losing subscribers after a price hike.

The brutal truth? You can predict a stock’s movement with eerie precision and still lose money if you ignore time decay. But don’t despair. Play it right, and you can turn this ticking clock into a profit engine.

Below, I’ll break down time decay in a way that won’t make your eyes glaze over, so you can stop bleeding money and start making smarter trades. Let’s dive in.

---

What Is Time Decay?

The value of an option isn’t just determined by the value of its underlying asset. Novice options traders often think that all they have to do is make the right prediction about an underlying stock or commodity and they can make a fortune by trading options. That’s not necessarily the case.

Option prices are affected by other factors as well. One of those factors is time. All other things being equal, the price of an options contract will decrease every day it gets closer to expiration.

In other words, if the price of the underlying security stays flat and implied volatility doesn’t change, you can expect the contract to drop in value every day. That’s because it’s easier to predict the outcome of the contract as it gets closer to expiration.

Think about it: if a stock is trading at $60 per share today, do you think it’s easier to predict what its price will be tomorrow or a year from now? Obviously, it’s easier to predict its price tomorrow.

Market makers adjust the value of options contracts downwards as they get closer to expiration because the outcome is a little more certain every day.

Keep in mind, options prices will decrease more as they approach the expiration date. In other words, time decay for an options contract that expires tomorrow is greater than the time decay for an options contract that expires in three months.

Time decay, by the way, is measured in theta. That’s one of “the Greeks” that options traders use to evaluate the profitability of trades.

When Would You Care About Time Decay?

As I mentioned above, people who are new to options trading think they can make money by simply making the right call about the underlying security. Often, they learn the hard way that they can’t.

They also have to consider time decay.

Let’s say that a new trader correctly predicted that a stock would rise to $50 per share on a specific date. He bought the $50 call option a month in advance for $4.00 per contract.

Unfortunately, by the time his prediction came true, that same contract traded for only $1.00. So he lost money even though he made the right prediction. That’s because he didn’t take into account time decay.

Here’s a key takeaway: all other things being equal, you’ll lose money when you buy an option.

The reverse is also true: all other things being equal, you’ll make money when you sell an option.

If you think a stock price is going to stay relatively flat in the near future, you can earn a positive return by selling a call or put option. If the underlying price and implied volatility stay the same, that trade can turn profitable.

The caveat is that your online brokerage will require you to set up a margin account if you sell options when you don’t hold a position in the underlying security.

Out-of-the-Money Options

An out-of-the-money options contract is one in which the underlying security is trading for lower than the strike price if it’s a call option or higher than the strike price if it’s a put option.

In other words, it’s an options contract that that doesn’t yet give the buyer the right to trade the underlying shares.

You’ll have no trouble noticing time decay in options that are out of the money. That’s especially true as they near expiration.

Why? Because they have less time to hit the strike price. There’s a better chance that they’ll expire worthless.

Things likely to be worthless in a few days usually don’t sell for a whole lot of money. That, again, is the reason why options decrease in value over time.

Case Study of Using Time Decay

Here’s a hypothetical example. Let’s say that XYZ Corp. is currently trading at $40.28 per share. You think it’s going to stay relatively flat in the near future, so you’d like to make some money off of time decay.

You check out next month’s options chains. You see that the $40.50 call option is currently has a bid of $1.45.

Upon some further research, you determine that’s a good price. So you sell the call option. That earns you a credit of $145 because options contracts are traded in batches of 100 shares ($1.45 x 100 = $145).

Please note: you didn’t buy the call option. You sold it. That means you’re short the option so you make money when its price drops.

Sure enough, XYZ stays flat during the next month.

At options expiration, the stock closes at $40.28 again. The contract you sold for $1.45 is now worth $0.60.

You buy back the contract for $60 ($0.60 x 100 = $60). That means you made $85 on the trade ($145 – $60 = $85).

You won even though the stock price didn’t move one way or the other. Time decay worked in your favor.

You would also have made money if XYZ dropped in value. That’s because the price of the options contract would have decreased along with the price of the underlying stock.

So you really had two ways to make money with that trade:

• Natural time decay reducing the value of the contract; or
• A drop in XYZ’s price reducing the value of the contract.

That’s why that would have been an ideal trade if you were bearish on XYZ. However, you still would have made money even though you were wrong about the price dropping. Time decay helped turn that trade profitable.

One last point: time decay and the underlying price aren’t the only market forces that affect the price of options contracts. Implied volatility also affects the price.

In the case of the XYZ trade, you would have lost money if implied volatility spiked after you sold the call option. That’s why it’s a great idea to look at all the Greeks before you place a trade.

---

Jim Fink is the chief investment strategist of several premium trading services, including Velocity Trader, Options for Income, and Jim Fink’s Inner Circle.