Today, were going to discuss the most complicated part about options time value.
Ive received a few questions from readers about this concept over the past couple weeks. So, I want to get right to it
The most important part of time value is the decay in price.
Heres how it works. Time value is considered the part of the options price thats based on the time remaining until it expires.
Now, time value decays over time and at a much faster pace as the expiration date gets closer.
To show what I mean, Im sharing the chart below. Ive used it several times at the Total Wealth Symposium our annual exclusive investment conference
As you can see, the closer we get to expiration (0 days), the more rapidly time value evaporates.
This is what most beginners dont understand.
Its the key factor in determining the premium you pay for any option. But time decay can become your biggest risk, too.
Let me explain
An Example of Time Decay
[Editor’s Note: This is not a recommendation. Its only an example to illustrate how time decay works.]
Lets say we buy an August $125 call option on Apple (Nasdaq: AAPL) today and its trading for around $8 per contract.
We have about 120 days before the option expires, and we paid $8 for a slightly out of the money call option on Apples stock.
Remember, an out of the money option would be worth nothing if it were exercised today. Its strike price is above where the stock is currently trading. So, the option premium we are paying is considered time value.
Lets assume the stock flutters around this area for the next 90 days. And in the end, the stock is up just about 4% to $127.
Since we paid $8 for the $125 calls, our breakeven price would be $133 per share.
With the stock well below that, thanks to the time value decay over the last 90 days, our option would now be down about 40% even though the stock is up 4% since buying our call option.
But heres the tricky part: If you look back at the chart above, youll notice time value drops significantly after we hit 30 days until expiration.
Over those last 30 days, if the stock stubbornly hangs around our $125 strike price, the option could go from a 40% loss to a 75% or even a 100% loss. And thats with the stock trading at or slightly above the price it was when we purchased the option.
With more volatile stocks, you can see even greater risk.
Back to the Second Rule of Trading Options
So, next time you try to decide which call option to buy, always keep time value decay in mind. Dont just look at how cheap the option is, especially if youre closing in on expiration.
A cheaper option doesnt necessarily mean less risk.
Time value decay is one of the main reasons I emphasize the importance of following a proven approach a profitable strategy. You dont want to fly blind when it comes to options trading.
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