Understanding Time Decay
Options are such a wonderfully flexible instrument, offering the trader a plethora of alternative opportunities and crossing the dimensional hum-drum that many financial pursuits suffer from. The incidence of time decay is the one feature that will succinctly characterise options, and the attraction they hold for a global financial community that has thrived on their activity for almost 30 years.
Primarily it is time decay that differentiates options from the making of a forward agreement or futures contract, the underlying purchase agreement of the ownership of stock, or an agreement to borrow or lend money. Time value represents a premium, to which is attached the privilege (not the obligation) of choosing whether or not to exercise the option and receive an exposure to the underlying, or to forgo the premium which has succumbed to time decay. In this sense it is similar to an insurance contract, which will only be claimed upon in the event of it being lucrative to do so. Otherwise it is considered prudent to continue paying a premium in return for the protection it offers. Both the seller and the buyer have different motivations, but both of them bargain for performance of a specific type.
Still, the premiums involved are not gratuitous, and depend on numerous input variables not the least of which are days to expiry and volatility. Long dated options of varying strike and maturity will be less and less distinguishable with the extension of time. This is due to the analogous difficulty there lies in differentiating between two distant and unidentifiable objects. When expiry is approaching however, the differences between options are as plain as day. Predominantly due to far more clarity shed on their short path to expiry, time decay begins to accelerate, as the pricing model has no need to shroud their price with the trappings of uncertainty.
Given the propensity that options have in lending themselves to the art of minimalism, while the sun is still high in the sky as it were, the decay of an options time value will be modest but yet realistic; time waits for no one. When the option is in its twilight; as expiry appears nigh, despite the fact that markets tend to display some level of spontaneity at expiry, an options price will decay more rapidly at an accelerated rate. Primarily this is due to the binomial pricing model (most suited to American options), having iterated through the multitude of possible prices, uses a pricing tree to identify all possibilities. As expiry approaches, this tree that set in a matrix of occurrences, grows considerably smaller, to the extent that the slim possibilities are almost non-existent. The proposition illustrating tossing a coin to result in two hundred consecutive heads, while entirely possible, is growing more and more unlikely with each head that is tossed.
As expiry approaches therefore, particularly in the last 30 days, time decay will accelerate until expiry. Curiously, the last day of trading will still find some residual time decay. Typically the time value of the at-the-money option will be 8 points and will expire immediately at zero if out-of-the-money.
Primarily it is time decay that differentiates options from the making of a forward agreement or futures contract, the underlying purchase agreement of the ownership of stock, or an agreement to borrow or lend money. Time value represents a premium, to which is attached the privilege (not the obligation) of choosing whether or not to exercise the option and receive an exposure to the underlying, or to forgo the premium which has succumbed to time decay. In this sense it is similar to an insurance contract, which will only be claimed upon in the event of it being lucrative to do so. Otherwise it is considered prudent to continue paying a premium in return for the protection it offers. Both the seller and the buyer have different motivations, but both of them bargain for performance of a specific type.
Still, the premiums involved are not gratuitous, and depend on numerous input variables not the least of which are days to expiry and volatility. Long dated options of varying strike and maturity will be less and less distinguishable with the extension of time. This is due to the analogous difficulty there lies in differentiating between two distant and unidentifiable objects. When expiry is approaching however, the differences between options are as plain as day. Predominantly due to far more clarity shed on their short path to expiry, time decay begins to accelerate, as the pricing model has no need to shroud their price with the trappings of uncertainty.
Given the propensity that options have in lending themselves to the art of minimalism, while the sun is still high in the sky as it were, the decay of an options time value will be modest but yet realistic; time waits for no one. When the option is in its twilight; as expiry appears nigh, despite the fact that markets tend to display some level of spontaneity at expiry, an options price will decay more rapidly at an accelerated rate. Primarily this is due to the binomial pricing model (most suited to American options), having iterated through the multitude of possible prices, uses a pricing tree to identify all possibilities. As expiry approaches, this tree that set in a matrix of occurrences, grows considerably smaller, to the extent that the slim possibilities are almost non-existent. The proposition illustrating tossing a coin to result in two hundred consecutive heads, while entirely possible, is growing more and more unlikely with each head that is tossed.
As expiry approaches therefore, particularly in the last 30 days, time decay will accelerate until expiry. Curiously, the last day of trading will still find some residual time decay. Typically the time value of the at-the-money option will be 8 points and will expire immediately at zero if out-of-the-money.
Posted by The Options Hunter Blog at 4/13/2010 10:35 AM 
Categories: options time decay
Tags: options time decay
Categories: options time decay
Tags: options time decay
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