Options traders who are familiarize with the term time decay understands the process under which the extrinsic value diminishes as the expiration date gets nearer. So, the extrinsic value of Options contract which the trader own will likely to diminish every day until the date of expiration. Whether the Options trader is holding onto a call or put until expiration.
It is a process which is in play! That’s why traders who are trading in derivative market should take this seriously. This isn’t a liner function. Means, it will not happen at the same rate throughout the trade of the Options contract. For instance, if an Options contract has expiration in 90 days then the erosion of the value of contract will vary with time. But, most important thing to remember is that “Time decay has more impact on the intrinsic value of the contract when there is one month to go.”
Although there are different ways to calculate the rate of time decay but you should be aware that it will be theoretical value only. Yes! You can use it to predict the direction and effect of time decay, but it is not something to completely rely on. Anyways, the time decay affects different traders very differently. To some Options traders, it really isn’t an issue: even though it will still in play.
Generally, the motto behind holding onto the Options contract until expiry is to make up enough for the loss of the extrinsic value on the underlying security. But, it is not a right thing to do. Instead, traders who are buying contracts in planning to close their position prior to expiration must take time decay seriously for each and every trade. To close a position timely and make a profit from the trade, the intrinsic value of any Options must increase by an amount larger than the impact of time-value decay.
For example, if you purchased a contract and the intrinsic value went up by 50 rupees but the time decay effect reduced the value by 55 rupees then you would be in a losing position. That’s why you need to consider the time decay and plan your entry and exit points for all your trades. So, it would be wise to use time decay to your advantage or at least neutralize its effects.
In doing so, you need to understand that time decay has a negative impact on the holders of options contracts and positive on the writers. To neutralize the negative effect, one can buy in the money (ITM) calls with some intrinsic value on a particular stock and write out of money (OTM) calls with no intrinsic value at the same time. If the stocks move favorably then the stock you bought could return profits even with the reduced profit due to loss of extrinsic value. In the end, you will be able to make the profit from the eroding extrinsic value due to time decay.
Hope, this article help you in understanding the effects of time decay and how it affects the Options traders. If you have any query or would like to suggest something then don’t forget to mention in the comment section below.