Investing In Options: Put Time On Your Side
As you know, there are four major variables in determining an option’s price – stock price, strike price, time, and volatility.
One of the most puzzling aspects of option trading for new option traders is time value premium decay.
For instance, I’ve heard from many novice option traders who were shocked to see the value of their call option falling when the underlying stock was rising.
Typically this is due to time value premium decay.
You see, an option is a wasting asset. The value of an option declines or wastes away over time. In essence, time is working against investors who buy call or put options.
And in these cases where the value of a call option is falling when the underlying stock price is going up, decaying time value has more influence on the option price than the rising stock price.
One interesting aspect about the time value premium is that the rate of decay isn’t constant. Time value decays more rapidly the closer you get to the expiration date.
In other words, an option one month away from expiration will lose time value premium much faster than an option with four months until expiration.
So, one way you can decrease the impact time value decay has on your long option positions is to buy options with more time until expiration.
Let’s say, you’re expecting XYZ stock to make a big move higher over the next two months. You could buy a call option that expires in two months. But you’ll be battling the peak period of time decay as the option nears expiration.
However, if you buy an option with four months until expiration (with the intent of only holding it two months), you’ll avoid holding the option through the period when time value is decaying the fastest.
Keep in mind, more time isn’t always better.
Don’t forget, options with more time until expiration are more expensive. The additional cost of buying LEAPs or long dated options will dramatically increase the size of your initial investment.
Obviously, this increases the amount of money you have at risk. And it also reduces the size of the gains in percentage terms.
Here’s the bottom line…
You should always try to minimize the impact of time value decay when you’re buying call or put options. But you also have to balance it with the added capital outlay and increased amount of money you have at risk when you buy longer dated options.
In most cases, you don’t want to hold long option positions through the expiration date. I recommend closing the trade with about one month until expiration to avoid the peak period of time decay.
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Category: Options Trading
