How Does Option Time Decay Work?

What is option time decay and how does it work in the context of stock options?  Option time decay is denoted by using the Greek word theta. Theta continues to be one of six indicators in option trading known as the Greeks. 

Options are a decaying asset. Option time decay is a feature of all options that basically means that an option will lose value as time goes on and it gets closer to expiration. So when you are looking to buy an option, the more time until expiration means the more the option will cost versus an option that has less time to expiration in which the underlying can move.

Theta specifically measures the sensitivity of an option’s value according to the passing of time.  Another way of saying this is that theta is the ratio of change in an option price according to the fleetingness of time before the expiration.  An easy way to remember this principle is to think of options as living assets that are wasting away as they age.  The value of an option naturally declines as time goes on.  If an option is fast-approaching the expiration date and is not ITM (In-The-Money) then its value will quickly decline, since it’s highly unlikely it will turn out to be profitable. 

Option time decay really starts to pick up speed in the last 30 days before expiration, assuming that the option isn’t already OTM or Out-of-The-Money).  How about options that are deep In-The-Money?  Ironically, in this case time value actually decays even more rapidly.  Why?  Probably because the market thinks these options are too expensive to hold especially when compared to other strike prices.  Therefore, holders of deep ITM options are wise to discount the time value (for a contract quickly approaching expiry) in order to attract new buyers.  The best way to remember this principle is this: the more certainty about an option’s expiry value you have, then the lower the time value is.  Likewise, the more uncertainty as to the option’s expiry value, then the greater the time value you get. 

This is an important part of choosing when and where to buy selling options.  Theta or option time decay is not precisely the same thing as Time Value, though they are related in thought.  The meaning to take home is basically that the time to expiration will have a major impact on the price of the option.  As the option comes closer to expiry then its chances of becoming more profitable are actually decreasing, and counting against it. 

Besides, predicting a stock price eventually becomes easier as every day passes and seems to resemble the last.  Therefore, it’s the time value that is decreasing as maturity approaches (and particularly so once past the 30 day mark). As the option ages, it loses what is called extrinsic value.

For an OTM contract, the option is made up of extrinsic value anyway, so understanding this time principle is paramount.

When trading options, the amount of time left for an option is what can make or break you. Look at a chart of a stock moving in an uptrend and you can tell it is going higher, but you cannot tell how high it will go and by when. If buying options, buy yourself enough time to be right on your bet.

When selling options, selling close to expiration limits your risk. The farther away from expiration you sell, the more premium you get but you do not get the quick decay benefits of option time decay until there are less than 40 days to expiration.

This is why I like to refer to selling options as “Selling Time”. As time passes, the options you have sold lose value. Making money while sitting around. Not a bad job if you can get it. And you can, if you sign up for my service.

Option Trading Books Reading List

What are Some Good Books on Option Selling?

What should you do if you are interesting in learning more about option selling?

The best way to get started is to read a few good books on the subject.

When I first got started I went to an expensive seminar. After two days I knew enough about options to be dangerous – to my myself. After trying to trade options based on what I had learned at the seminar I realized, after losing a lot of money, that there was more to it.

So I started researching books on options, videos online, websites, etc. Here are some of the best books I found on options and trading in general.

Options Books

One of the most advertised books is The Complete Guide to Options Selling: How Selling Options Can Lead to Stellar Returns in Bull and Bear Markets by James Cordier and Michael Gross. It goes into detail about option writing strategies that can improve your profit. It reviews all of the basic mechanics of selling options and profiting as well as strategies that are insider-quality, easy to follow, and that have a high-probability approach. The book is written to appeal to the new investor, not a mathematician. In this book you can look forward to learning why selling options is more profitable than buying, and specific strategies for selecting various types of markets. Keep in mind that this book is about futures options, not equity options.

One of the first books I got was Options As A Strategic Investment by Lawrence Mcmillan. I would say this is the “bible” of options books. Why? Because it is huge and covers all the basics of option trading and then some.

Most option books cover the basic strategies but they leave out when you should use these strategies and what to do when the trade goes bad. Very few books talk about adjusting trades. The best one I found that does is The Option Trader’s Handbook – Strategies and Trade Adjustments by George Jabbour and Philip Budwick.

My favorite book on Option Selling is Generate Thousands In Cash On Your Stocks Before Buying or Selling Them, by Samir Elias. I myself have only used a couple chapters of this book but it was a very interesting with good ideas.

Wall Street Money Machine by Wade Cook is also a good read. But read this book for motivation only. Most of the examples and numbers in this book were over exaggerated but still, I liked it and enjoyed it when I was starting out so you might too. Most of the book was on covered calls.

A couple other “should” read book on option volatility are Option Volatility and Pricing by Sheldon Natenberg, and The Volatility Edge in Options Trading by Jeff Augen. Both are technical and for advanced options traders.

Books On Trading

How To Trade In Stocks by Jesse Livermore is a must read. Livermore was the best stock trader of all time and his strategies are now copied by just about every firm on Wall Street.

Trade Your Way To Financial Freedom by Van Tharp is good to give you some basic guidelines on trading.

Trading For A Living by Alexander Elder is also very good. I have all of Elder’s books even though they focus a lot on technical investing, he does show how traders with different styles can all make money if they get the basics right.

Credit vs Debit Spread—Which is Better?

Are you wondering which is better: option trades that result in a credit or trades that result in a debit?  Simply put, you’re asking whether you should choose a credit spread or debit spread strategy.  Let’s consider both options in more detail. 

A credit spread (also called a net credit spread) involves the investor selling one option then buying another option.  The second option is in the same class and also shares the same expiry date.  However, there are different strike prices between the two options.  In this instance, the new investor gets a net credit for entering this position.  He is looking forward to the spreads either narrowing or expiring in order to get a profit.  A credit spread is basically a conservative strategy in investment.  It is designed to earn a moderate level of income while also limiting your potential loss.  In this circumstance, you are buying and selling options on the same index in the same month.  Remember, the only thing different is the strike price.  The most common credit spreads are the Bull Put Spread and the Bear Call Spread.

What about debit spreads?  First of all, investors have to pay to enter a debit spread (or net debit spread).  This option is when the investor buys an option with a higher premium but must sell the option for a lower premium.  How will this bring profit?  Because the investor is hoping that the premium of his two options will widen due to the market.

Another issue to consider is that of what type of strategy you are going for with credit or debit spreads; as in bull or bear?  The bull or bear strategy involves doing what you’re doing—selecting selling two options, but choosing both call or put options, and with the same expiration dates.  (The strike prices can be different)  The basic philosophy of bullish in stocks is that you buy low and sell high, which can be called an optimistic outlook, or bearish, buy high and sell low, which is a pessimistic approach.  Both of these may work with any given strategy.

When you bring credit/debit into the equation, there are more issues to resolve.  First know that with a credit spread, the required margin will be the same as the difference between both strike prices.  This is the most you can lose.  Your capital requirement will be reduced since you can apply the credit of premium to the margin.  Now let’s consider debit spreads on the opposite end of the spectrum.  These are called debit spreads because your broker is actually going to debit your account for the net premium, as opposed to giving you credit.  The most you lose with the debit spread is the premium net.  Gains are limited and this option does not require a margin.

In deciding which works better for you consider the time value involved.  If you know a stock or underlying is going to move in a certain direction and you know to what price a debit spread can result in more profit. On the other hand, if all you know is a stock is going to move in one direction or not much, than you can place your trade in the other direction.

Let’s look at an example. If you use technical analysis, you can determine support and resistance lines, as well as trendlines. Say a stock is trending up and has support at $50 and is trading at $54.39 right now.

You feel the stock is going to go higher but you do not know by when. Your best bet is to sell a 50/45 Put spread. You sell the 50 put and buy the 45 put in the same month. For the sake of the example, you will trade the current month with the fewest days to expiration. As long as this stock stays above $50 you make the full amount of the credit.

If you think the stock is going to go to $60 in 2 weeks, you can use a debit spread. You would buy the 55 call and sell the 60 call in the same month. You would get the max profit if the stock is above $60 at expiration. But if the stock does not move up, your options will lose value everyday and eventually expire worthless.

With a credit spread, if the stock does not move, you still make money.

Basically we are talking about two sides of the same coin. A debit spread for one trader is a credit spread for another.

Market Commentary

I frequently get asked which way I think the market is headed. Especially after the event of recent days where the markets have been on a sprint to the upside but with pull backs the last couple days.

I usually respond the same way every time.

“I don’t know.”

If I could predict the market I wouldn’t be here blogging, I would be out enjoying my billions.

Believe me, I have tried to learn how to predict the markets. That’s what technical and fundamental analysis is – an attempt to understand and predict market direction.  In the end, I gave up.

I cannot predict market direction. The pundits on TV and radio can’t do it, all the blogs and gurus online with their fancy explanations, charts, candles, lines, and waves can’t do it with any regularity and neither can the folks on Wall Street.

So why bother?

Why not trade in a way where it doesn’t matter which way the market moves?

Makes sense to me. And that is why I love option selling.  It does not matter what is going on in the market, what news comes out or doesn’t, the premium I sell loses value everyday, and I profit.

Let me give you an example. This month I have a McDonald’s (MCD) trade on. I want MCD to stay within a range. A couple days after I put the trade on, MCD moved higher and almost out of the range. So I adjusted the trade and made the range bigger.

That day a member emailed me with news that there is a rumor going around the MCD is going to raise its dividend. That might be why it went higher. And if the news about the dividend is correct, it might go higher still.

This member wanted me to know that this trade was not a good idea. He was warning me to what could happen. Thanks to this member, who had my best interests at heart, I began to worry about this position.

What if he was right and MCD shot up higher?

But after a while I calmed myself down and realized that it was not in my hands. If MCD went higher I would evaluate the position, adjust if possible or in the worst case scenario take a small loss. But the odds were on my side.

As it turned out, MCD has behaved fine since and the trade is right in the middle of the profit zone. Let’s hope it stays that way.

But my point is that it does not matter if the dollar is stronger or weaker. It does not matter what oil or gold do. The markets still move in ranges and if you play the ranges, 8 times out of 10 you will win. And those wins allow you to make much higher returns that you will in a savings account, a CD, a money market fund, or a mutual fund.

More Investors Trying the Options Play : Wall Street Journal

An interesting article today in the WSJ talk about how more and more small investors are trading options. The sad par tis most of these investors do not the true danger of the options they are trading. Only too late do they realize that buying options is a losing proposition.

The good news is the more options are traded the more liquidity they will have and the more competition among brokers will lead to lower commissions for all of us.

here is the article:

http://online.wsj.com/article/SB125202073403184971.html?ru=yahoo&mod=yahoo_hs#articleTabs%3Darticle

By JEFF D. OPDYKE

Most investors are hoping stock prices push higher. The short-sellers want stocks to sink lower. And then there is Marlene Sackheim: She hopes the market goes nowhere.

The 57-year-old chief financial officer of her husband’s pain-management clinic in Pensacola, Fla., trades options for herself and other family members. Her preferred strategy — colorfully dubbed a naked strangle — rakes in the money when the Standard & Poor’s 500-stock index has no big swings. That has been tough in a year when stocks first tumbled and then soared. Still, by constantly adjusting her positions, Ms. Sackheim says she is “having a great year so far.”

Whether seeking income, mitigating risk or just speculating on price movements, investors are trading options in record numbers these days. Cumulative volume on the nation’s seven options exchanges hit a record 2.4 billion contracts through the first eight months of the year, 2% higher than the same period in 2008 — though volume surged even higher last fall when the financial crisis exploded.

Of course, professional money managers account for much of the volume. But Charles Schwab Corp. found in a July survey that 47% of its “active” investors regularly trade options these days, up seven percentage points from last summer. The number of investors attending Schwab’s options-trading seminars “has grown dramatically this year,” says Randy Frederick, Schwab’s director of trading and derivatives. He has hosted seminars in more than 40 cities this year.

Options trading can be risky. Depending what side of the trade you are on, an option involves the right or obligation to buy or sell a stock or index at a certain price on or before a certain date. In the most conservative strategies, the most an investor can lose is the price of a contract, often just a few dollars. At their most speculative, options can leave investors exposed to huge losses.

Some options strategies work best in up markets, others in down. And some work best when markets go sideways. Bet wrong and you can lose big. Options traders who were betting on market stability earlier this year, “incurred some big losses” in the volatility of late February and March, says Jim Bittman, a senior instructor at the Chicago Board Options Exchange’s Options Institute. In a two-week stretch, stocks fell more than 16%, only to rise 17% days later.

Stephen Figlewski, a finance professor at New York University, formerly traded options professionally and enjoyed it. But he adds: “I’m not sure I’m any better off than having put money in a Vanguard index fund. Lots of strategies seem smart, and people can make money at it for years. But then suddenly the year their strategy fails, they lose everything they made before — and more.”

Many of the most popular options strategies today are focused on generating income. Investors sell options contracts to other investors and collect premiums in return. If the contract expires worthless — and 30% of all options contracts do — the seller keeps the premium. If the contracts end up “in the money,” the seller of the option is obligated to buy or sell the underlying shares at a predetermined price.

A popular strategy is selling covered calls. Mike Pera, a 65-year-old retiree in Eagle River, Wis., does that regularly by selling call options on stock he already owns. Selling a call is an obligation to sell shares at a certain price until a certain date.

In one recent example, Mr. Pera owned U.S. Steel Corp. at $27 a share and sold call options obligating him to sell those shares at $30 several weeks into the future. He received a premium of 50 cents per share, or $50 for each 100-share contract. U.S. Steel closed below $30 at expiration, and the options were never exercised. Mr. Pera pocketed the premium and immediately sold more calls, bringing in additional money.

“I’m not comfortable with the rapid ascent of stocks since March, so selling calls is a stream of income in a market that’s really in flux,” he says.

But he faces a risk selling calls into a market rally. Had U.S. Steel jumped to $40 a share, Mr. Pera’s profit would have been limited to $3.50 a share — the $3 price gain from $27 plus the 50-cent premium for selling the call. But he would have missed out on an extra $9.50 in potential gains because he sold his shares.

Schwab’s Mr. Frederick has been advocating another income-oriented strategy that involves selling a put. He calls it “an excellent way to ultimately own shares you’re comfortable with if the market comes down, yet bring in a little cash in the meantime.”

Say you want to own Amazon.com Inc. at a price lower than the current $78.50. You could sell a $70 put for the October expiration, giving another investor the right to sell Amazon shares to you at that price. For that, you would receive a premium of $1.41 per share.

If Amazon’s share price declines, the other investor will sell you the shares at $70. You will end up owning Amazon at an effective price of $68.59, or $70 minus the premium you already pocketed.

If Amazon doesn’t hit $70, you keep the premium and then can sell another put. The downside: Amazon’s share price soars, in which case you would have done better by buying the shares outright. And, of course, if Amazon shares fall sharply, you will take a loss, though it will be offset in part by the premium income.

The Philosophy Of Option Selling

I just finished a book by Dean Koontz called The Good Guy.

It’s about a guy in a bar that gets mistaken for a hit-man. This guy then goes to find the person who is going to be killed and tries to save her, ultimately falling in love and dodging the killer throughout the book.

Anyway, there was one conversation the killer had with the hero that was interesting. The killer tells the hero,

” Good guys finish last, Tim” and the hero responds,

“Maybe not if they stay in the race.”

To me that sounds like adjusting option trades. When we get in an income option trade we want the underlying stock/etf/index to stay right where it is. It can move up and down as long as it does not stray too far from where we want it to be.

Sometimes though, it does move, and it hurts our position. That’s why we adjust. And the philosophy behind adjustments is to stay in the race. If we can stay in the trade and give the underlying enough time to come back to us, we have a greater chance of making money.

So with the adjustment we are giving our underlying more room to move around, and we, as the good guys are still in the race.

Otherwise we would have to exit at a loss. Adjustments give our underlying the ability to move around and eventually come back to us.

The down side is that adjustment cost money. They lower our potential profit as well. So sometimes in hindsight, it is better not to adjust. But you just never know, so I say it is always better to adjust and make a little, than take a risk, not adjust and risk losing a lot.