Time Decay
Time decay is a crucial component traders consider when deciding when/where to buy sell options. Time decay can be represented by a Greek term know as Theta. Don't worry too much about the Greeks for now, we will take a look at Option Pricing and Greeks a little later.
As we saw from the previous article on Extrinsic Value (also known as Time Value), we saw that an options time to maturity (or time to expiration) has a huge impact on the price of the option. That is, as the option moves closer to expiry (i.e. running out of time) its chances of becoming more profitable decrease with every day. As you can probably imagine, predicting an approximate stock price becomes easier every day. For example, you will have a much greater chance of predicting tomorrows closing price for Microsoft than you will of predicting next Fridays closing price.
Because of this, the Time Value of an option decreases exponentially as the maturity date approaches - especially as the time to maturity passes the 30 day mark. Below is what the theoretical value of an option looks like as time passes.
As you can see, after the 30 day mark, an option will begin to lose its extrinsic value quite rapidly. For out-of-the-money options this is key, as the entire option is made up of Extrinsic Value.
So, it stands to reason that you would not really want to go out buying a lot of options with less than 30 days to expiry (all other things being equal), unless you had strong convictions about the direction of a stock price - or you just might happen to be the person that likes a good bet.
Although these ideas are classic option trading fundamentals, not every body shares the above opinion of time value trading. David Rivera, author of the ebook called "Option Trading Secrets", takes an alternative view to time decay trading. David says that you can actually profit by buying options with more time decay, as long as you sell another type of option to give you can edge.
David's approach is very unique and throws a little spanner into traditional option thinking. OptionTradingSecrets is a great investment if you plan on trading options based off time decay advantages.
David also has a free newsletter that you can sign up to. He frequently provides free option trading picks based off his unique method. You can sign up for free at DeltaNeutralTrading.
Comments (1)
shesha1970
November 4th, 2009 at 9:14am
hey add ore exmples from other markets
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