Time Decay Of An Option

This is one of the most important concept when it comes to option investing - understanding the concept of time decay.

The concept of time decay is kinda easy to understand if you think about in terms of insurance policies.

Let's compare two insurance policies which provide the exact same coverage.

1. Plan A provides a coverage for 30 days
2. Plan B provides a coverage for 3 days

Now, which do you think will cost you more money?

Well, it will be Plan A right?

So let's put a price to it.

1. Plan A (30 days) = $20
2. Plan B (3 days) = $2

So when Plan A is only left with 3 days, we can also expect the value of Plan A to be left with $2.

This is known as the concept of time decay.

Why Is Time Decay Important?

When it comes to buying options - we need to understand the concept of time decay.

Imagine if we are buying carton of milk - do we want to buy with a longer expiry date or shorter expiry date.

Probably longer right?

Because we know that, once the milk expired - it would have lost its value.

However, we know that time decay is unavoidable - the milk will eventually expire.

So is there a point in considering time decay?

Well, the answer is because of the different speeds of time decay.

Speed Of Time Decay

The price of an option contract is made up of two components:

1. Intrinsic Value
2. Extrinsic Value (Time Value + Other factors*)

*Covered in next chapter

The time value of the option is what will decay to zero at the end of expiry.

Here's how the time decay looks like:

The key idea is this:

1. The longer the date to expiry, the slower the time decay
2. The shorter the date to expiry, the faster the time decay

So remember that, the time value of the option will eventually fall to zero - and it falls faster when the date to expiry is shorter.

This is an important concept as it helps us to choose the date to expiration of our options.

As a general rule, if you are option buyer - you want to choose a longer term expiry date so that your option's time decay is much slower.

And if you are an option seller, you want to choose a shorter term expiry date to take advantage of the rapid time decay.

The selection of date of expiration of the two strategies will be discussed later in the individual section.

Quiz

Note: One of the biggest reasons why the options hub was built as there were too many people who get burnt because of the lack of knowledge of how options works and its risks involved. This resource hub aims to equip beginner investors with the knowledge of options and how they can manage their risks when investing with options.