If you short options, should you choose options with about a month remaining because that is when most of the decay is?
Shorting (or writing) options is a strategy used to generate income through receiving a premium for selling the right either to buy or sell an option. The premium the option writer receives is the price of the option at the time of selling (opening the position). This price is made up of two components: intrinsic and time value. Intrinsic represents the value between the strike price and current stock price if the option were exercised now. The remaining value is called time value.
Time value is higher for at the money option (ATM) positions compared to out of the money (OTM) or in the money (ITM) options. At expiry of the option, time value will be zero. The eventual fall of time value to zero is known as time decay and hence in order maximise the premium received, it is helpful to know the behaviour of time decay on the options price.
For an option which is at the money (ATM) the rate of time decay accelerates as the options expiry nears. Generally an options position will lose two thirds of its time value, in the last third of time, due to the accelerating rate of time decay as the position nears its expiry. Therefore, shorting ATM options with a month remaining will give you more time decay (theta) compared to shorting ATM options with two months remaining, assuming everything else remains constant.
For out of the money (OTM) or deep in the money (ITM) options, time value is very small as there is less chance of the option reaching or surpassing the strike price. Time decay works differently for such options and generally decelerates close to expiry.
In conclusion knowing when time value is greatest, when it decays the most and how its rate of decay changes can assist an option writer in maximising the premium received. However, there are other more important factors to consider such as the outlook and volatility level of the underlying stock during the option life that will of course influence if and when an option writer decides to short an option.
By Stephen Karpin, General Manager, CommSec
The views expressed in this article are those of Stephen Karpin, a representative of Commonwealth Securities Limited (CommSec) ABN 60 067 254 399 AFSL 238814. CommSec is a wholly owned but non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 23495 (the Bank) and a Participant of the ASX Group. As this information has been prepared without considering your objectives, financial and taxation situation or needs, you should, before acting on this information, consider its appropriateness to your circumstances and if necessary, seek appropriate professional financial and taxation advice. CommSec Margin Loan is a facility provided by the Bank and is administered by CommSec. Please be aware that a CommSec Margin Loan exposes you to unfavourable movements in the value of shares and units in managed funds, and possibly to margin calls. Please be aware that you are personally liable for any shortfall that occurs should your entire portfolio have to be sold to answer a margin call where there have been falls in the market value of your investments. Only investors who fully understand the risks associated with gearing into investments should apply. All applications are subject to the Bank’s credit approval process. Fees and charges apply. Please consider the Product Disclosure Statement, and terms and conditions, issued by the Bank and available from www.commsec.com.au before making any decisions.