They are a wasting asset and will decay over time. Covered call writers have a decision to make as to which expiration date to write.
Is it better to write near-term options and take advantage of rapid time decay, or write longer-term options to reduce transaction frequency and costs and get more downside protection? The answer is "it depends"; let's take a look Non-Linear Time Decay Time decay is a reduction in an option's price caused by the passage of time. It normally accelerates as an option nears its expiration date.
Each day that passes causes a small amount of time premium to disappear, until there is none left when the option expires.
Note: Intrinsic value arises when an option gets in the money. This should make the above concepts more tangible. Through this presentation, we are making the assumption for simplification that implied volatility levels remain unchanged and the underlying asset is stationary.
This erosion of time premium is the source of a covered call writer's income. If one is merely interested in maximizing time premium per day that you collect, then the near-term option will be the option to write as the annualized rates of return will be higher than the longer-dated options. However, if you are dealing with a low-volatility underlying stock then the near term option may not offer enough time premium to make the trade worthwhile after transaction costs.
You may have no choice but to write an option that goes out 2, 3, or even 6 months in order to get enough premium to get a decent return after commssions.
Investors who have core holdings time decay option non-volatile stocks will often do this -- write out of the money options that have months of time to expiration.
- Time Decay In Options
- The Options Industry Council (OIC) - Theta
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Because the options are out of the money they leave themselves some upside potential, and because the options have several months before expiration, the premiums are more than enough to cover the transaction costs. Increased Protection Another reason to write options farther out than the near month is downside protection.
- Options TradingTrading Strategies Options time decay can be one of the most insidious forces to lose you money as you buy call and put options.
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- Theta Time Decay – Key Points About Selling Options Part 8 - Black Box Stocks - Trading Software
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The more time you sell the more premium you will receive. A 2 month option will give you more premium than a 1 month option, which increases your downside protection.
If you believe the underlying is at risk of decreasing in value over the next few months, you may be better off selling a 2 or 3 month option instead of a near-month option or, possibly just sell the underlying and wait until you think you have a bullish case before getting back in.
If you are going to hold the underlying stock across some anticipated volatility event like earnings then you may be better off writing an option that has more premium in it than the near-month option, as a defensive measure.
Theta is represented in an actual dollar or premium amount and may be calculated on a daily or weekly basis. Theta or time decay is not linear.
The increased premium gives you a bit more protection, at the expense of a lower annualized rate of return. Taxes There may also be tax reasons to write options that go farther out. For example, by selling an option that expires in January of next year instead of one that expires in December time decay option this year, you may be able to delay any tax event resulting from an option exercise until next year.
Note that this is a tricky area, though. If you sell options that are deep in the money then the IRS may take the position that it was a constructive sale at the time you sold the option as opposed to the time it was exercised.
Of course, if you're doing covered calls in a non-taxable account like an IRA then you can ignore these tax issues.
- Time decay is a measure of the rate of decline in the value of an options contract due to the passage of time.
- And what kind of exposures are there.
- How Options Time Decay Destroys the Prices of Calls and Puts
- To explain further, we must look at how the price of an option is effectively made up of two separate components: intrinsic value and extrinsic value.
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