Time decay is one of the most fundamental concepts in trading options. It refers to the idea that your option’s value lessens as you get closer to its expiration date.
That’s why it’s one of the first things we learn when we’re starting out.
Time is always ticking away.
For a buyer, the longer it takes for the move they’d anticipated to play out, the less likely it is that their trade will succeed.
That’s because time decay erodes a bit more of the option’s value every day (weekends included).
And time decay doesn’t happen in a straight line. It accelerates the closer you get to the option’s expiry.
Even if a big move takes place, if it’s late in the option’s life, it still might not be enough to cover the lost value from time decay.
So to avoid being on the wrong side of time decay, traders often look to option writing strategies instead.
By writing (selling) an option, you can make time decay work in your favor.
Which Option?
While selling an option, it’s not always clear which option you should write.
And it’s here that an option’s strike price is so important.
So let’s consider a popular option writing strategy to see what I mean. With a covered call, you sell call options on shares you own to generate income.
If an option is a long way “out of the money” (OTM), that means the option’s strike (exercise) price is a long way above the current share price. So your sold option would have little chance of being exercised.
That can be a positive if you want to keep your shares over the long term. But the downside is that you’ll generate very little income.
On the other hand, if you write a call option that’s “in the money” (ITM – i.e., the strike price is below the stock price), you’ll generate far more income.
But this comes with a much greater chance of being exercised and locking you into selling your shares below the market price.
So if you want to keep your shares, you’d only consider this ITM strategy if you thought that the stock faces a short-term retracement.
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Maximize Time Decay
The best way to capture the most value is to write your call options as close to the money (“at the money,” ATM) as you can.
The goal is to maximize profit by capturing the most time value. But you may also want to give yourself some wriggle room to lessen the chance of the option being exercised.
This means that if you’re neutral to slightly bullish (and you want to own your shares long term), then you’d sell your call options slightly above the current price.
For example, say a stock is trading around $100. You think the maximum price it might reach within the option’s life is $103–104. So you’d write your calls with a $105 or $110 strike price.
You’d only write an ATM option (at $100) in this example if you were convinced that the stock had already peaked and would drift lower before expiration.
The trick is to find the right balance between generating income and preventing your option from being exercised.
And if you get that balance right, accelerating time decay works more in your favor every day.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict