Options Math for Traders: How To Pick the Best Option Strategies for Your Market Outlook, + Website

CHAPTER 7

Time Value and Decay

Option expiration and the resulting regular decay in value set options apart from nearly every other financial vehicle. Options are a wasting asset and as such the time value, meaning the value of the luxury of waiting to make a decision, will go toward zero as expiration approaches. At expiration this time value becomes zero, you don’t have the luxury of waiting any longer to make up your mind.

Every option is a contest between value, which is volatility in the underlying asset, and price, which is really just the accumulated time decay. That battle between erosion and volatility means that the two factors offset each other. If volatility helps your option position, even if it’s movement in a particular direction, then the passage of time and the resulting decay generally hurt your position. For example, if you’re long the at-the-money call option, then you want movement to the upside and you want a ton of it, the more the better. But if you’re long that call option, then the passage of time is your enemy because the price of that option will erode. If you need time to fly then you want the market to sit. If you need the market to move then you want time to stand still.

Option traders have to be careful how they talk about time decay. The entire value of an option doesn’t decay; it’s only the time value of the option that erodes. The inherent value, that is the value by which the option is in-the-money, will never erode; if an option is worth $1.75 ...