Options...you must know about time decay in options

Options 

Options contracts are instruments that give the holder of the instrument the right to buy or sell the underlying asset at a predetermined price. An option can be a 'call' option or a 'put' option. 

A call option gives the buyer, the right to buy the asset at a given price. This 'given price' is called 'strike price'. It should be noted that while the holder of the call option has a right to demand sale of asset from the seller, the seller has only the obligation and not the right. For eg: if the buyer wants to buy the asset, the seller has to sell it. He does not have a right. 

Similarly a 'put' option gives the buyer a right to sell the asset at the 'strike price' to the buyer. Here the buyer has the right to sell and the seller has the obligation to buy. 

So in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller of the contract has only the obligation and no right. As the seller of the contract bears the obligation, he is paid a price called as 'premium'. Therefore the price that is paid for buying an option contract is called as premium. 

The buyer of a call option will not exercise his option (to buy) if, on expiry, the price of the asset in the spot market is less than the strike price of the call. For eg: A bought a call at a strike price of Rs 500. On expiry the price of the asset is Rs 450. A will not exercise his call. Because he can buy the same asset from the market at Rs 450, rather than paying Rs 500 to the seller of the option. 

The buyer of a put option will not exercise his option (to sell) if, on expiry, the price of the asset in the spot market is more than the strike price of the call. For eg: B bought a put at a strike price of Rs 600. On expiry the price of the asset is Rs 619. A will not exercise his put option. Because he can sell the same asset in the market at Rs 619, rather than giving it to the seller of the put option for Rs 600.


What Does Time Decay Mean?

The ratio of the change in an option's price to the decrease in time to expiration. Since options are wasting assets, their value declines over time. As an option approaches its expiry date without being in the money, its time value declines because the probability of that option being profitable (in the money) is reduced. 

Also known as "theta" and "time-value decay".


Time decay of an option begins to accelerate in the last 60 to 30 days before expiry, provided the option is not in the money. But in the case of options that are deep in the money, time value decays more rapidly. The market finds these options too expensive compared to other strike prices or futures. As such, the holders of deep-in-the-money options nearing expiry discount the time value to attract buyers and in turn realize the intrinsic value.

The greater the certainty about an option's expiry value, the lower the time value. Conversely, the greater the uncertainty about an option's expiry value, the greater the time value.




What Does In The Money Mean?

1. For a call option, when the option's strike price is below the market price of the underlying asset.

2. For a put option, when the strike price is above the market price of the underlying asset.

Being in the money does not mean you will profit, it just means the option is worth exercising. This is because the option costs money to buy.

What Does Out Of The Money - OTM Mean?
1. For a call, when an option's strike price is higher than the market price of the underlying asset.

2. For a put, when the strike price is below the market price of the underlying asset.

Basically, an option that would be worthless if it expired today.

What Does Underwater Mean?
1. The condition of a call option when its strike price is higher than the market price of the underlying stock.

2. The condition of a put option when its strike price is lower than the market price of the underlying stock.

Also known as "out of the money."

Time decay, also known as theta, is defined as the rate by which an options value erodes into expiration. The value of the option over parity to the stock is called extrinsic value.
Since an option is a depreciating asset, meaning it has a limited life, the extrinsic value in the option will wither away daily until expiration. This decay is not a linear function meaning it is not equally distributed between all of the days to expiration.
As the option gets closer to expiration, the daily rate of decay increases and continues to increase daily until expiration of the option. At expiration, all options in the expiration month, calls and puts, in-the-money and out-of-the-money must be completely devoid of extrinsic value as noted in the time value decay charts below.
As more time goes by, the options extrinsic value decreases. Again, it is important to note that the rate of this decrease is not linear, meaning not smooth and even throughout the life of the option contract. An option contract starts feeling the decay curve increasing when the option has about 45 days to expiration. It increases rapidly again at about 30 days out and really starts losing its value in the last two weeks before expiration.
This is like a boulder rolling down a hill. The further it goes down the hill, the more steam it picks up until the hill ends.
By selling the option and owning the stock, the covered call seller captures the extrinsic value in the option by holding the short call until expiration.
As mentioned earlier, an options loss of extrinsic value over its life is called time decay. In the covered call strategy the options time decay works to the sellers advantage in that the more that time goes by, the more the extrinsic value decreases.
Key Point The covered call strategy provides the investor with another opportunity to gain income from a long stock position. The strategy not only produces gains when the stock trades up, but also provides above average gains in a stagnant period, while offsetting losses when the stock declines in price.
We have now seen how a covered call strategy is constructed and how it is supposed to work. Keep in mind that the trade can be entered into in two ways. You can either sell calls against stock you already own (Covered Call) or you can buy stock and sell calls against them at the same time (Buy Write).