Investing in the stock market and day trading, in particular, is not for those who are overly responsive to emotions. There are so many things to learn and many variables that impact your ability to turn a profit; two of those variables are buying and writing (or selling) options, which some see as a gamble but others see as insurance. However, irrespective of the way you look at it, there is much for the beginning investor to learn about options.
Yes, options decay during the day. But, they do not do so in a linear fashion. As the options get closer to the expiration date, their rate of decay increases. Additionally, options have both extrinsic and intrinsic value. When it comes to time decay, it is just the extrinsic value of an option that decreases.
The rest of this article will explain a few topics related to this question, including what are options, what is “options decay,” how extrinsic and intrinsic values work. Additionally, we will also discuss why options are beneficial, and when you should consider purchasing options. So, read on!
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Table of Contents
What Are Options?
First, options are NOT stocks; instead, they are contracts that give investors the chance to buy and sell a stock at a predetermined price, called the “strike price,” and this option is active for a certain period of time. While they are contracts, investors can walk away from them at any point during the period of the contract. This ability means investors are not obligated to use the option. If they choose not to walk away, they can also let the option expire.
There are two available options:
- Call Option – This contract allows investors to buy shares later at the predetermined price within a certain amount of time.
- Put Option – This contract will enable investors to sell at a later time at the predetermined price, again, within a certain amount of time.
Both options are available for various lengths of time. Still, it is essential to note that the 30-90 day options are considered best for beginners. This recommendation is because if the strike price goes up, you have an immediate profit; however, if it does not move, or worse, goes down, you still have time to cut your losses without losing more than you can recover from.
What Is Option Decay?
This term is also known by the Greek term, Theta, and “time decay.” For background, greeks are what is used to describe risk in options. In addition to Theta, they include Delta, Gamma, Vega, and Rho, and some of the minor greeks. Regardless of what it is called, option decay is the rate at which an option’s contract declines over time.
Option decay begins when the agreement is written, and the reason it is confusing to novice investors is because the decline does not happen in a linear fashion. For example, it does not lose value at a specific amount per day; instead, the loss accelerates the closer an option gets to the expiration date.
You might loosely think of options decay like the way a boat or car depreciates over time. When dealing with options, an inevitable, and expected loss naturally occurs with time.
The reason investors are so attuned to this greek is because theta, or options decay, is the only risk measure that is absolute. The decline will happen no matter what else happens in the market.
In short, because time does not stop, the option will lose value over time. The question is how long or short of a time will the option have before it loses value.
Savvy investors know that they have to consider the other Greeks as well, but for beginners and the purposes of this article, we will assume that everything else stays the same and only theta will change.
To break this down a little further, when you buy a long option, your theta value is negative, so time works against you. With a short option, theta is positive, so time is on your side. The closer your option gets to its expiration date, the faster options decay occurs. In short, you’re betting on when this acceleration will begin.
It is crucial to remember when using theta as part of your strategy, that options have both intrinsic and extrinsic values. The intrinsic value is the amount the option would be worth if you chose to exercise it right now.
Extrinsic value is slightly more complicated because you take the option’s premium and subtract the intrinsic value. Also, options have to be watched closely because once they expire, they have no extrinsic value.
There are many ways that traders use options, but to help explain this concept, we will use the calendar spread strategy because it is sometimes easier for novice traders to grasp.
When using the calendar spread strategy, the option, whether a call or a put option, is bought when it is close to its expiration date, and then you purchase the same option type at the same strike price. Then, you chose a deferred expiration date. This strategy limits your risk because generally, what you stand to lose is the amount you paid for this spread, and buying the two options with different expiration dates acts as an insurance policy for you.
There are other Greek “sensitivities” that factor into all parts of options trading, and many more strategies, but they are beyond the scope of this article.
How Do Intrinsic and Extrinsic Values Work?
Options are akin to gamble, and many investors use them successfully because they understand how the option’s value works, which is primarily theoretical. For you to also succeed, you need to understand two different concepts:
- Intrinsic Value – This value assumes the built-in profit of an options contract at a specific time point. So if you set an option to buy a stock for $45 that, in theory, will have a $5 profit at a specific point in the day, the $5 earning is the option’s intrinsic value. Note that an option’s intrinsic value will never be negative.
- Extrinsic Value – This value is also called “Time Value,” and this is where options get confusing. But essentially, the extrinsic value is the money you pay for the possibility of benefiting from the stock’s volatility.
So in the above intrinsic value scenario, if you bought the stock at $50 and it continued to trade at $50, there would be no intrinsic value; however, there is extrinsic value. Let’s say the cost of your contract was $5; you would be paying that amount to take advantage of any upward movement in the security.
How Does Time Decay Work?
The longer the time option, the better the value, and this is because the stock will have more time to increase in price over time. Once the option expires, it is gone. It cannot be repurchased or sold, although another option for the same stock could be purchased.
Why Are Options Beneficial?
Investors purchase options as a way of betting that the stock price will move. Therefore, they buy options for three main reasons:
- Investors make money if stocks go up. Traders buy call options when they are betting that the stock price will go up. This way, they can buy the stock at a lower price during the contract period and sell it immediately. The option you bought means that even if the stock price goes up, you still get to buy that stock at the option’s predetermined contract price.
- Investors make money if stocks go down. Investors use Put Options when they are betting that the price of the stock will go down.
- Investors will use options to hedge a trading position. Hedging reduces risks, which also means reducing potential profits, but it can also reduce anticipated losses.
So, the initial question, “Do Options Decay During the Day,” may now seem like an inconsequential one. However, the effects of Theta, which Investopedia defines as the “rate of decline in the value of an option due to the passage of time,” is crucial in your ability to make a profit from the options purchase.
In essence, since the option has an expiration date, it becomes less valuable the closer it gets to that date. So, while theoretically, it does decay throughout the day, it does so at a much slower rate earlier in the contract than it does later in the contract period.
When Should You Purchase Options?
It is essential to recognize that when dealing with options, timing is everything. So if you do not have a lot of time to invest in watching the market, options may not be your best avenue.
The most apparent reason to purchase an option is if you think the option is underpriced. You might also buy an option to protect your stock price if you feel the market will take a negative turn. Again, however, this option has an expiration date, so timing is still everything.
Many people make money trading options regardless of the threat of options decay. Still, the safest way to work with options is to understand not only options decay (Theta) but also the put-call ratio, the options chain, and all of the greeks. The learning curve is vast for beginners, and the information is often overwhelming, not to mention that it is never all in one place.
Therefore, you should purchase options after doing a lot of research and then do so in increments until you understand how the market works.
Options allow traders to profit even when the market is sideways or even down, but you have to know what you are doing. Remember, if it were easy to utilize and make money from options, everyone would be doing it, so take the time to learn what there is to know about options before proceeding.
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Conclusion
In the end, theoretically, options decay every day, but they decay faster as the option nears its expiration date, which is during the day. Although many times purchasing options is considered a gamble, because of this decay, at least in part, it can also be considered an insurance policy.
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