Time-Decay in Options Trading Explained (Simple Guide)
Options contracts tend to decrease in value as they get closer to expiration. That’s called time-decay.
Simply put: you can lose money with options even if you make the right call about the underlying security but ignore time-decay.
On the other hand, you can also let time-decay work in your favor and earn healthy returns with stock options.
In this guide, I’ll explain time-decay so you’ll know how to use it in your online trading.
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.
Read Also: How Does The Bull Call Spread Strategy Work?
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 are 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.
Real Life Example of Using Time-Decay
Let’s say that Cisco 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, Cisco 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.
Keep in mind: you would also have made money if Cisco 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
- A drop in Cisco price reducing the value of the contract
That’s why that would have been an ideal trade if you were bearish on Cisco. 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 Cisco 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.