Time Value of an Option

Time Value of an Option Contract

Do you know the value of time in options trading? We can’t bottle, touch, or make any more of it. The time value of an option, our most precious commodity, is ticking away, and there’s no way to stop it. Many of us would give anything to get more of it at the end of life. 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. It’s too little, and you see your entire position expire worthlessly.

The option’s time value 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. It’s too long, and you leave precious money on the table. So, where is the sweet spot? Luckily, you can buy time as an options trader but can’t stop the clock. Here’s how to make the most of your time when trading options.

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.” 

The ultimate question remains: How does one pick the right option 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.

Time Costs Money

Generally speaking, more time costs more money. For example, the weekly contracts may cost $.20 while the monthly contracts are $1.00, and the quarterly contracts 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.

You agree that the longer you hold on to it, the smaller it gets. How would you prevent it from melting away? One way would be to buy a bigger tray and make a bigger cube.

Since a longer hold time costs you more money, you must 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.

Time Value of an Option Example

Expiration Time Value of Option

This is an example of expiration dates on options contracts.

Chart Patterns

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 are broken. In light of this, buying contracts with shorter expiration dates may be more appropriate (and profitable) if you’re someone who trades based on these technical patterns.

It all boils down to your overall risk tolerance 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 out which type of trader you are and plan accordingly.

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

If your style is higher risk, a shorter expiration date is likely your go-to play. With this approach, you buy the least time for the move you are after.

For one thing, it maximizes your leverage but increases your time decay rate. Short-term expires can and most often do yield much higher gains than longer ones.

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.

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.

If 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 an Option Be Negative?

When it comes to the time value of an option, can it be negative? 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.

Time Value of a Weekly Option Contract

This is an example of weekly options contracts on $WMT.

Building Free Positions

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 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. The total percentage of premium remaining on or near expiration is at its 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 are significantly lower.

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

Let’s say you risk a $500 loss from your paid premium. In the best-case scenario, you see potential gains of $5000, 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.

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Day Trading Options

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

Ensure you have the best day trading system when venturing into the world of stock market trading.

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. But they go into the red less often should the underlying move against you.

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

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

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

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

On the other hand, you may find yourself in 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 hold it until expiration, with the contract worthless and your premium gone.

Final Thoughts: Time Value of an Option

Contrary to what most people believe, trading options is safe. Tricky, yes; risky, no. We have countless options and 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 Bear is a great place to begin your options strategies.

Frequently Asked Questions

The calculation of the time value of an option is done by extrinsic value. Each contract has a number assigned to it. It can be found on any options chain.

Options contracts have time value, which refers to the premium portion of the contract. It's the amount of time remaining until contract expiration.

The time factor of an option is the premium for the contract. How much time is left until contract expiration.

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