Trading options is one of the most efficient ways to take quality profits out of the market. The built in leverage allows a trader to lower their capital requirements, decrease their risk, and increase their ROI!  Who wouldn’t want to trade options?

However while options do provide great leverage and a very flexible instrument for trading, they are not always a walk in the park.  Options have some built in challenges that simply trading a stock does not have.

One of the biggest challenges is option time decay, as I like to call it, the “silent capital killer”.

Option Time Decay

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.

The lack of understanding time decay is one of, if not the biggest, reasons people lose money with options trading.  It is this component of option pricing that scares so 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.

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.  You can always find this theta number in the greeks section of your option chain.

Now the bigger 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 8 weeks to expiration but by the time the option is 3 weeks to expiration that theta may have increased to .025.  This is more than a 2x increase in time decay.  Then as 2 weeks to expiration rolls around that theta may now be .04 and increasing every day.

It may not seem like  a lot to lose a penny or two per day from your option, however if you are losing 4 of those pennies, and it stacks up for 10 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 gone poof!

Take a look at this theta curve taken from an SPY at the money option:

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 bad news is a lot of trades are doomed from the start because the trader does not understand this very important component of option trading.

The good news is you can mitigate a lof of the risk by simply following a few rules:
  1. 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.  I 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.
  2. Avoid buying weekly options.  I often have people asking me if they should buy weekly options and I usually say no.  The reason is because a weekly option with only 1-2 weeks to expiration has the absolute highest rate of time decay.  You have enough trouble trying to pick the direction of the trade, why set yourself up to fail by having an option that is melting option premium faster than an ice cube in the desert?
  3. Buy 4 weeks more time than you need.  If you plan to be in a trade for 2 weeks, go ahead and add 4 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 it’s value because of rapid time decay!  You can simply avoid that by buying an option with an extra 4 weeks to expiration.

It might seem simple, and it kind of is!  You can avoid a huge percentage of your time decay battles by simply following these rules above.  However, if you start breaking these rules, I can assure you time decay will start to be a problem. In fact you might even be doomed from the start.  If you really want to doom your trade just break all 3 rules, that will seal your fate!

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