How To Put Time In Your Favor With This Income Strategy
Time decay is an issue that affects all option traders. How it affects you depends on your strategy and the actual positions in play, of course. Nevertheless, the concept of time decay is either working against you or to your advantage.
All things being equal, the value of call options and put options decline as they approach their expiration date. This erosion in value is technically referred to as “theta.” The options Greek theta measures the rate at which a call or put contract loses value on a daily basis. The higher theta is, the faster the option contract is losing value.
Credit: Options Industry Council
The rate of time decay is a very important concept for option traders because it affects the profitability of different strategies. For the put selling strategy we use over at Income Trader, for example, theta works in our favor. As options sellers, we benefit as the value of an option erodes.
Let’s dive a little deeper to understand how theta affects the prices for option contracts. We’ll do this by looking at the two main components of an options price.
Intrinsic vs. Extrinsic Value
The value of every option contract is comprised of two different measurements: intrinsic value and extrinsic value.
Intrinsic value is the difference between the underlying stock’s price and the strike price of the option. In common parlance, this is referred to as how far the option is “in the money”.
Extrinsic value is the difference between an option’s market price and its intrinsic value. In other words, it is the remaining portion of the option contract’s value. This is the additional premium an option buyer pays for the potential upside if the underlying stock moves higher (for call contracts) or lower (for put contracts).
For example, consider a stock that is trading at $47. We own a three-month call option with a $45 strike price. Assume the price of this call contract is $4.50. In this instance, the intrinsic value of the contract is $2 (because the option is $2 in the money). The extrinsic value for this contract is the remaining $2.50. This is the speculative value of the option contract, which represents the potential for a stock to trade higher over the next three months.
It’s important to note that for calls and puts that are out of the money, the entire value of the contract is extrinsic. This is because the contract will expire worthless if nothing else happens. If the stock price moves to a point where the contract is actually in the money, then it has intrinsic value.
This brings us back to the concept of theta. Time decay only affects the extrinsic portion of a contract’s value.
So there are two primary things to consider when determining the rate at which a contract will lose value. First, we need to figure out how much of the value is eligible for time decay. (We do this by determining the amount of extrinsic value in the contract.) Second, we need to note how much time is left until the options expire.
Timing is Everything
For option contracts with a significant amount of time left before expiration (six months or more), theta is typically very low. This is because one less day of trading before expiration doesn’t significantly alter the long-term potential for the intrinsic value of the contract to increase.
However, things change as an option contract approaches its expiration date. The rate of theta, or time decay, picks up significantly. Ultimately, the extrinsic value is trading down to zero. Eventually, the option will only be worth its intrinsic value upon expiration.
This has very important ramifications for a put selling strategy, for example. Ideally, we want to sell put option contracts that have a relatively high theta or rate of time decay. This is because theta increases as we get closer to the expiration date and that is an important part of our ultimate profitability.
If you are beginning to dabble in selling put options, try selling puts that expire in the next four to eight weeks. This gives you enough extrinsic value to make a decent amount of income. But you also collect that income in a short amount of time, allowing you to move on to the next trade.
Of course, if you ultimately want to own the stock at a lower price, this may alter you strategy a bit. But putting the maximum amount of theta in your favor helps to increase profits and generate reliable income. And it can be especially effective during periods when the underlying stocks are stable or moving higher.
P.S. If you want to make high-probability income trades, then you need to check out Amber Hestla over at Income Trader. Each week, she recommends Instant Income trades that have helped her readers generate hundreds (even thousands) like clockwork. Click here to learn more.