What Is the Time Value of an Option and How Do You Calculate?

Do you know the value of time in options trading? We can’t bottle it, touch it or make any more of it. The time value of option our most precious commodity, ticking away, and there’s no way to stop it. Many of us, at the end of life, would give anything to get more of it. What I’m talking about is time, and it’s our most precious commodity. Likewise, the value of time in options trading can not be understated. Too little, and you see your entire position expire worthless before your eyes.

What Is Time Value of Option?

  • The time value of option is the price an investor is willing to pay over the price it’s currently trading at, based on the probability it’ll reach that price by expiration. Too much time and you leave precious money on the table. So, where is the sweet spot? Luckily, you can buy time as an options trader, but you can’t stop the clock. Here’s how to make the most of the time you have when trading options.

A Quick Recap

One of the main differences between buying stocks and options contracts is the impact of time, namely time decay.

For the most part, time decay does not affect stock prices. On the other hand, when you buy an options contract, you agree on an expiration date.

For most of the optionable stocks, there are typically weekly, monthly, and quarterly expiration dates. To make a long story short, common stock shares don’t expire, while options contracts do.

We refer to this ticking time clock as “Theta.” Check out the chart below for an example of Theta at work:

Time Value of Option

Choosing Your Option Expiration Dates

The ultimate question remains: How does one pick the right options expiration date? Well, it all depends on your trading style. Think of it this way; if you are primarily a day trader, you will likely want to trade the nearest expiration cycle.

Whereas, if you’re a swing trader, you may want more time in the trade. So, you might want to find expiration cycles of around 25-50 days.

Generally speaking, more time costs more money. For example, the weekly contracts may be going for $.20 while the monthly’s are $1.00, and the quarterly’s will set you back more than $3.00.

And since options contracts are decaying assets, the longer you hold them, the more their value decreases. If this all sounds Greek to you, think of holding an ice cube in the palm of your hand.

I think you would agree the longer you hold on to it, the small it gets. How would you prevent it from melting away? One way would to buy a bigger tray and make a bigger cube.

Since a longer hold time costs you more money, you need to be smart. You want to execute your trading plan in as little time as possible; to leave the least amount of money on the table. But this is much easier said than done.

Chart Patterns and the Time Value of Option

For starters, specific chart patterns – such as rising wedges, falling wedges and coil patterns, complete quicker than others.

They tend to yield sudden movements in the stock price once support and resistance is broken. In light of this, if you’re someone who trades based on these technical patterns, it may be more appropriate (and profitable) to buy contracts with shorter expiration dates.

It all boils down to what your overall risk tolerance is as a trader. What are you comfortable losing?

Some traders can risk more and still sleep at night while others insist on protecting capital at all costs. Figure our which type of trader you are and plan accordingly.

Options theta is going to affect your profit and/or loss. Make sure you read the charts correctly.

Trading Style: High-Risk High Reward

Time Value of Option

If you are someone who’s style is one of higher risk, a shorter-term expiration date is likely your go-to play. With this approach, you buy the least amount of time for the move you are after.

For one thing, it maximizes your leverage but increases your time decay rate. In fact, short term expiration’s can and most often do yield much higher gains than longer-term expiration’s.

However, this is only true if the underlying stock moves in your favor. Don’t forget to check IV crush on any options you’re trading.

What Type of Options Contract Has a High-Risk High Reward?

Typically, if you’ve had gains of 1000% or more, they probably came from out of the money (OTM) weekly contracts.

These weekly, short-dated OTM options are gamma sensitive. What I mean by this is they will move more every time the price of the underlying stock moves.

And because gamma sensitivity is at its highest point on expiration Fridays, we commonly refer to these as “lotto” plays.

Provided that you can nail the quick move in price action, they will generate a significant return quickly. Make sure to avoid emotional trading; especially on options.

Can Time Value of Option Be Negative?

  • When it comes to the time value of an option can it be negative? The answer is no. The time value of an option cannot be negative. Positive time value, however, shows the probability that a stock will move into the money at expiration.

Building Free Positions Trading Weekly Options

Many who trade weekly options do this by building “free positions.” Fundamentally, these positions aren’t free but consist of 100% profits rather than being paid for with your liquid capital.

Because these “freebies” are much easier to let ride in lotto-style scenarios, some consider them “risk-free.”

One well-known strategy using this technique is to day trade your way into an earnings announcement. With the profit from those trades, you then roll them into a “free position” before the earnings report.

And you do this very near (or on) the Friday expiration where gamma sensitivity is compounded.

Take a look at the time decay graphic posted at the beginning. You can see the total percentage of premium remaining on or near expiration is at it’s lowest point.

In simple terms, it means the cost of the OTM options contract will be dirt cheap because the odds of it ending ITM is significantly lower at this point.

However, if it goes your way on Friday, it could mean major bank. And what’s great about options is that your risk is limited to just the premium you paid.

Let’s say you risk $500 loss in the form of the premium you paid. In the best-case scenario, you see potential gains of $5000, which is a 1000% ROI.

In extreme, albeit rare cases, gains of 10,000% or more are possible. You’d have a whopping $50,000 return on your meager $500 “lotto” play.

What Time Frame Should You Use to Day Trade Options?

Short-term expiration’s are ideal for patterns spotted using lower time frame intraday charts – think the 1 minute, 5 minute, 15 minute, and sometimes the 30 min.

Make sure you have the best day trading system when you’re venturing in to the world of stock market trading.

Trading Style: Better Safe Than Sorry

If reading what I wrote above made you squeamish, a contract with a longer-term expiration date might be more digestible to you.

This low-risk approach won’t show you the quick gains the short term contracts will show you. But they go into the red less often should the underlying move against you.

As mentioned above, swing traders may see expiration’s of 25-50 days out more appropriate based on higher time frame intraday and daily charts.

When trading options, the “safer” bets involve trades using more time than is needed. To do this, you would generally buy a strike that is already in the money (ITM) or at the money (ATM).

Both of these trades will still see gains if price moves in your direction, just not at the same rate as the higher risk scenarios above. T

he main reason being that the downside is significantly lower if the price moves against you (and has a better chance of expiring with value) than that of an out of the money trade.

On the other hand, you may find yourself if a situation where your timing was right, but your strike was off.

For example, if your strike is too far out of the money (OTM) near expiration, it may be hard to close your position. In other words, you could end up holding it into expiration, with the contract worthless and your premium is gone.

Conclusion of the Time Value of an Option

Contrary to what most people believe, trading options is not risky. Tricky yes, risky no. We have countless options strategies at our fingertips, each utilizing time as a key factor.

If you want to learn how the other pricing factors (like delta, gamma, and implied volatility) play a role in options trading, join us today. Bullish Bears is a great place to begin your options strategies.

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