Foundations of Trading: Options [Part 8]

Welcome back to our current Foundations of Trading Options blog series. Today we will focus on a topic that has been mentioned in more than a few of Chris' option classes but has yet to be covered in my blogs: Time Decay. However, before we do, as a reminder, if you wish to review any blogs in this or other series we have done, please click on the Foundations of Trading blog category on the right-hand side of the page, which will instantly bring up all the blogs from our program for your review and now to the topic at hand.

As an options trader, you face some inherently built-in challenges from which stock traders are immune, and time decay is one of the main obstacles. Time decay works like this: as an option gets closer to expiration, a small amount of the premium will be taken out of the option price. This becomes a challenge, particularly as an option is getting very close to expiration. Every day a small portion of the option will be reduced until expiration happens, at which point, the only value remaining is any intrinsic value in the option. This component of option pricing scares many traders away from ever working with options. However, the trader who takes the time to learn how to use options and understand the pricing will find that time well spent.

So How Does It Work?

We can have a good idea of what the time decay component of an option will be simply by looking at the option greeks. Theta is the value that tells us how much the option premium will decay every day, assuming the underlying stock value stays the same price. For example, let's say an option has a theta of .01; we know that every day, assuming the stock price stays the same, that option would decrease by 1 penny.

However, the more significant challenge is not theta itself but the reality that theta speeds up the closer an option gets to expiration. An at-the-money option may have a theta of .01 with eight weeks to expiration, but by the time the option is three weeks to expiration, theta may have increased to .025. This is more than a 2x increase in time decay. Then as two weeks to expiration rolls around, theta may now be .04 and increasing daily. It may not seem like a lot to lose a penny or two daily from your option. However, if you are losing 4 of those pennies, and it stacks up for ten days, that's .40 off your option. For an option with a starting premium of only $1.60, that represents 25% of the premium that has been lost.

In the image above, notice how the time decay speeds up the closer the option gets to expiration. Misunderstanding this component causes most people to lose money with options. The good news is you can mitigate a lot of the risk by simply following a few rules:

Always buy options that are in the money. In the money, options have intrinsic value, which subjects less of the option premium to time decay. This will help lower the risk of trading options. We usually suggest buying 1-2 strike prices in the money. If you go too far in the money, there may not be enough open interest to make the option a liquid trade, so stick with 1-2 strike prices in the money.

Avoid buying weekly options. The reason is a weekly option with only 1-2 weeks to expiration has the absolute highest rate of time decay. You have enough trouble picking the trade's direction, so avoid setting yourself up to fail by having an option that is leaking option premium at an accelerated rate.

Buy four weeks more time than you need. If you plan to be in a trade for two weeks, go ahead and add four more weeks to the option month you choose to buy. Otherwise, as you get closer to the end of your trade, your otherwise good option trade starts to lose all its value because of rapid time decay! You can avoid that by buying an option with an extra four weeks to expiration.

In Closing

Remember, if you follow these few simple rules, you can avoid a considerable percentage of your time decay battles when trading options. As always, if you have any questions regarding the contents of this blog or any other blog in this series, please stop by to see our teachers, Josh and Chris, in our Group Coaching sessions which happen every Thursday. That way, you can ask Chris to dive a little deeper into any topic from any of his presentations. For access, please contact Rebekah at for details on Group Coaching sessions. Thank you for reading, and we look forward to seeing you next week!