Options Price Explained: Time Value Decay
Today, we’re going to discuss the most complicated part about options — time value.
I’ve 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.
Here’s how it works. Time value is considered the part of the option’s price that’s 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, I’m sharing the chart below. I’ve 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 don’t understand.
It’s 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. It’s only an example to illustrate how time decay works.]
Let’s say we buy an August $125 call option on Apple (Nasdaq: AAPL) today and it’s 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 Apple’s 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.
Let’s 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 here’s the tricky part: If you look back at the chart above, you’ll 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 that’s 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. Don’t just look at how cheap the option is, especially if you’re closing in on expiration.
A cheaper option doesn’t 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 don’t want to fly blind when it comes to options trading.
It’s the second of three rules I told my readers to trade options by two weeks ago.
If your stock isn’t on the move to make up for the time value premium you’re paying, then the decaying price will eat away at your returns — and hand you more losses than winners down the road.
Today, I invite you to learn all about my No. 1 options strategy. See for yourself how the proven approach I follow in Quick Hit Profits leads us to profitability over and over again.
There will be some losses along the way. That’s true for any service.
But over the last four and a half years we’ve followed this approach, we have beaten the market by nearly 4X, leading to big profits over time.
And if you’re new to options, you’re in the right place. My goal in the Weekly Options Corner is to lay down the fundamentals of trading options.
That includes everything from how to find the perfect option to when you should pass on a potential opportunity.
Next week, I’ll explain what a weekly option expiration is and when it’s ideal to use it.
In the meantime, if you have any questions, you can send them in to me and my team at WeeklyOptionsCorner@BanyanHill.com.
Chad Shoop, CMT
Editor, Quick Hit Profits
Investing has consumed my life since college. While double majoring in finance and economics at the University of North Carolina at Greensboro, I founded the university’s economics club, joined the finance club and participated in the Chartered Financial Analyst research competition to represent our school.