When researching how options work, you’ll often hear about a concept called “time decay.” This concept describes how much an option’s value can decline in a set timeframe. But when you face such a time crunch, you might wonder: do options decay overnight?
Options usually decay overnight. The decay rate depends on the contract’s expiration date and how much the stock is expected to move. An option that expires in a week will decay faster than one set to expire in 150 days if other variables like the stability of the asset’s value are the same.
The time decay of options is something traders have to factor into their plans if they intend to trade them. But how much do you really know about options and how they decay? If not much, worry not! The following article will help you decipher all about options decays and thereby decide if options trading is right for you.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
How Options Trading Works?
When traders purchase an options contract, they’re purchasing the option to buy or sell the underlying asset at a set price. They aren’t obligated to buy or sell the asset, though they often will if the asset’s price moves enough to make it attractive. This can especially be an attractive option when trading physical assets like barrels of oil or agricultural products like grain because the traders aren’t required to take physical delivery of the product being traded.
A “call” occurs when the asset is purchased, and a “put” happens when it’s sold. Options are also frequently called “derivatives” because the underlying asset’s actual value is a major variable in determining the option’s value.
Investors often include derivatives in their portfolios as a hedge against undesirable price moves in stocks or indexes. Traders who track the S&P 500 index can buy a put option granting the right to sell the index at a certain price within the next two years if they expect the index price to drop below that price, for instance.
Options also provide a way to speculate on stocks without actually buying the stock. Most options cost only a fraction of the actual stock price and could be seen as a sort of “down payment” on the stock’s price.
If the stock price delivers as expected, the trader can earn the full value of the difference between the price set in the option and the stock’s actual value. If the option expires without being filled, the trader holding the option typically only loses pennies on the dollar compared to holding the actual stock.
Who Takes the Risk When Buying or Selling Options?
Those who create options contracts — known as “contractors” — usually work on the assumption that investors will simply let some derivatives expire without exercising them.
Due to the time decay mentioned earlier, the options will typically be worth the most when created. Their creators can sell them at the maximum possible extrinsic value, which is defined as the perceived value to their current owner.
The contractor is usually confident that the contract will work out in his or her favor. If factors outside of the contractor’s control cause an unexpected scenario, the damage won’t be problematic.
The primary risk to both the current holder of the contract and the contractor who issued it is that the asset described in the contract can move drastically in a direction that they didn’t expect. Most experienced professional traders have likely seen cases in which valuable tools in their toolkit, such as technical analysis based on price charts, failed due to an unexpected event.
This phenomenon was most recently seen in the recent pump of GameStop stock carried out by members of the Reddit community, which created a “short squeeze” that analysts say cost short-sellers as much as $13 billion.
Short sellers are investors who “borrow” the stock to sell at the current price with the intention of buying it back at a lower price in the future. Meanwhile, the winners in the GameStop pump — those on Reddit — reported using their gains to pay off student loans and buy gaming consoles for patients at a children’s hospital.
(Slight disclaimer: Most pumps are illegal. Use caution when participating in one or observing a sudden, sharp increase in an asset’s price.)
How Time Decay Factors Into Options?
The concern that options can decay overnight is based on the idea that fewer people will want to buy an option when it gets closer to expiring. A derivative holder may be stuck with three options:
- Sell the option for a lower price than he or she paid for it, which is a loss and an admission that the trader made a mistake;
- Exercise the option in the form of either a “put” or a “call”;
- Let the option contract expire, which would mean that the trader has taken a 100% loss on that derivative.
The general rule of thumb is that options decay faster when they get closer to expiring. Overnight decay especially becomes noticeable when the expiration date for a stock option is within weeks or days of expiring.
If any exceptions exist, they usually involve unusual circumstances like the recent GameStop pump. Although acting out of “Fear of Missing Out” is rarely advisable, some investors might have liked to exercise a call option to buy a GameStop stock at a lower price and then quickly sell it for a respectable profit.
How to Plan for Options Decay?
The concept of options decay simply means that it wouldn’t make sense to buy options purely to “Hold On for Dear Life,” or “HODL,” as the cryptocurrency community likes to put it. Professional investors would simply consider it a poor strategy to hold derivatives until they expire regardless of market conditions.
Investing in derivatives is primarily a bet that an asset will move within the time frame described by the derivative in question. If you buy a call option, you’re betting that the asset’s value will rise above the agreed-upon price enough to make it an attractive investment. If you buy a put option, you’re betting that the price will drop enough to make it worth selling at the agreed-upon price.
It makes sense to do your research on an asset before you buy derivatives. Investors generally like to have access to historical price data and recent news related to any particular asset. While this isn’t foolproof, experienced traders can look for patterns in past performance that indicate the likelihood that an asset will move in a certain direction.
Sometimes a stock will be undervalued because the company posted a moderately disappointing, though still healthy, quarterly report. In that case, it might make sense to buy a call option that’ll expire in half a year or more.
Sometimes an asset will appear to be overvalued because it saw steady gains over the past year, but some recent worrying news indicates that the bubble is about to pop. Then the investor might want to buy a put option.
When armed with solid research and the discipline necessary to stick to a plan, options decay need not be a significant concern when trading derivatives. It simply requires the ability to keep an eye on actual conditions so that the investor can get the full advantage of actually exercising an option.
Author’s Recommendations: Top Trading and Investment Resources To Consider
Before concluding this article, I wanted to share few trading and investment resources that I have vetted, with the help of 50+ consistently profitable traders, for you. I am confident that you will greatly benefit in your trading journey by considering one or more of these resources.
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Conclusion
If you’re at all interested in trading derivatives, the concept of options decay is a factor to keep in the back of your mind. Derivatives can decay overnight, though it’s usually only noticeable when they’re about to expire. However, if you plan for it, trading options can make an excellent hedge against the risks involved in trading assets because they’re typically less expensive than buying or holding the actual asset.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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