Options contracts are unique financial instruments. One thing that makes them different from forex pairs, ETFs, or stocks is that they have a finite expiration date. And, upon reaching expiry, all option contracts become untradeable.
Read on to learn more about stock options time decay and how it can impact your equities market risk exposure.
What Is Time Decay?
According to Investopedia, time decay is “a measure of the rate of decline in the value of an options contract due to the passage of time.” Time decay is represented by ϴ, the Greek letter theta.
So why do options contracts lose their value over time? The answer is simple: expiration. Remember, options are perishable financial instruments. When they reach expiration, they are settled and become untradeable. At that point, options are valued in two ways:
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In the money (ITM): When a stock option expires ITM, it has a monetary value. For call options, an ITM contract is one in which a stock’s price is above the contract’s strike price. In the case of puts, a contract is ITM when stock price is below the contract’s strike price. When stock options expire ITM, the holder may exercise the contract and profit from the difference between the market price and strike price.
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Out of the money (OTM): When a stock option expires OTM, the contract is worthless. The holder loses the premium paid as the right to buy or sell a block of shares at strike is void. Call options finish OTM when stock price is beneath strike; put options expire OTM when stock price is above strike.
The possibility of a contract settling OTM is the basis for stock option time decay.
This means three things:
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As a contract nears expiration, there is less time to trade the option or exit the position at a gain.
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If a call is well beneath strike, the value decreases dramatically as expiry approaches.
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If a put is well above strike as expiry draws near, the contract loses significant value.
Each of these factors works to increase the negative impact of time decay on stock options.
Risk Exposure
A critical aspect of options to remember is that stock options become riskier to hold as contract expiry approaches. In other words, as contract settlement approaches, theta increases. As theta increases, the pricing of stock options becomes more volatile.
To illustrate this point, assume that Sam the stock options trader has purchased one IBM July 1 call with a strike price of $100. The premium was $3. Here is Sam’s position:
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Sam has the right to purchase 100 shares of IBM at $100 per share on July 1.
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Sam paid a $300 premium to secure this right.
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If IBM’s price is over $100 on July 1, Sam can exercise the contract for a gain.
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If IBM’s price is below $100 on July 1, the contract becomes worthless and Sam loses the premium.
The zero-sum nature of contract settlement is the primary driver of the risks posed by stock option time decay. If Sam holds the IBM option until expiration, the financial rewards may be substantial. However, if the option expires worthless, then Sam’s premium is lost. That’s why contracts approaching expiration are less valuable than those with an extended duration until they expire—there’s limited time for OTM options to expire ITM and reduced opportunities to offload the contracts at a gain.
Want to Learn More About Stock Option Time Decay?
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