Trading options is one of the most efficient ways trade the market. The built-in leverage options provide allows a trader to lower their capital requirements, decrease their risk, and increase their ROI. However, while options do provide great leverage and are a very flexible instrument for trading, they are not always a walk in the park. Options traders face some built-in challenges which stock traders do not. One of these is 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.
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 eight weeks to expiration, but by the time the option is three weeks to expiration that theta may have increased to .025. This is more than a 2x increase in time decay. Then as two 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 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 which has been lost.
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 lot of the risk by simply following a few rules:
By following a few simple rules, you can avoid a huge percentage of your time decay battles when trading options.