While a number of other factors (such as Delta, Gamma, and implied volatility) weigh into overall option pricing, a sound understanding of Theta and the impact of time decay is highly important.
Most investors and traders new to options markets prefer to buy calls and puts because of their limited risk and unlimited profit potential. Buying puts or calls is typically a way for investors and traders to speculate with only a fraction of their capital. But these straight option buyers miss many of the best features of stock and commodity options, such as the opportunity to turn time-value decay into potential profits.
When they establish a position, option sellers collect time-value premiums, paid by option buyers. Rather than struggling against the ravages of time value, the option seller can benefit from the passage of time, and time-value decay becomes money in the bank even if the underlying is stationary.
For option writers (sellers), time-value decay thus becomes an ally instead of a foe. If you have ever sold covered calls against stock positions, you can appreciate the beauty of selling time value.
In this article, I focus on the importance of time value in the option-pricing equation. But before turning to a detailed look at the phenomenon of time value and time-value decay, let's review some basic option concepts that will make it easier for you to understand what we mean by time value.
Options and Strike Price
Depending on where the underlying price is in relation to the option strike price, the option can be in, out, or at the money. Let's look at this relationship while keeping in mind our central focus on time value.
When we say an option is at the money, we mean the strike price of the option is equal to the current price of the underlying stock or commodity. When the price of a commodity or stock is the same as the strike price (also known as the exercise price), it has zero intrinsic value, but it also has the maxim! um level of time value compared to that of all the other option strike prices for the same month.
Figure 1 provides a table of possible positions of the underlying in relationship to an option's strike price.
As can be seen in Figure 1 above, when a put option is in the money, the underlying price is less than the option strike price. For a call option, “in the money” means that the underlying price is greater than the option strike price.
For example, if we have an S&P 500 call with a strike price of 1100 (an example we will use to illustrate time value below), and if the underlying stock index at expiration closes at 1150, the option will have expired 50 points in the money (1150 - 1100 = 50).
In the case of a put option at the same strike price of 1100 and the underlying at 1050, the option at expiration also would be 50 points in the money (1100 -1050 = 50).
For out-of-the-money options, the exact reverse applies. That is, to be out of the money, the put's strike would be less than the underlying price, and the call's strike would be greater than the underlying price.
Finally, both put and call options would be at the money when the strike price and underlying expire at the exact same price. While we are referring here to the position of the option at expiration, the same rules apply at any time before the options expire.
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