Options-Time is Money

Don't just stand there, do something! If you want to invest and just wait for the rising tide to carry your boat, stock options probably aren't for you. Nowhere is it more obvious that "time is money" than in trading options. Traders are faced with not only correctly predicting the underlying security's future price, but also choosing the appropriate option time period for the price change to take place. Once that's established, the trader can then decide which option strategy is best to capture profit while minimizing risks. Some stock option traders mistakenly figure they can easily make the transition from stocks to options. As easy as falling off a log, right? Maybe not. There are differences that option traders need to keep in mind when making the transition to stock options.

Stocks Don't Expire. Options Do

The major difference between stock and option trading is the impact of time on stock and option prices. With stocks, time is a trader's ally, as the stocks of quality companies tend to appreciate in value over time. However, with options, time is an "enemy." As each day passes, there is a decline in the value of the time pre-mium for the option. An option trader must not only correctly estimate the direction of price movement the option but also the time frame for the movement. The more time an option has to make the hoped-for movement, the better the chances of it happening. Conversely, as time on the option decays, the probability of the movement happening diminishes; thus, the importance of the "time value" of an option. Because of time value, as an option moves closer to expiration date, the time component of the premium declines more rapidly. An option trader who holds a position for too long will face the inevitable decline in premium value.

Given the accelerated impact of time decay, the closer the options are to the expiration date, option buyers are well advised to purchase more time before expiration than will be needed. Normally, once into the last month of an option period, time decay picks up speed and the option can lose value rapidly. That is why it's a good idea to "buy time" in an option even though the option premium will be higher. This allows the option buyer to avoid the especially painful time decay, which occurs in the final month before expiration. Moreover, the greater the certainty about an option's value at expiration will usually produce a lower premium time value; the greater the uncertainties about an option's value at expiration, the greater the premium time value.

When an option is in the money, premium time value also decays more rapidly.

The market usually views an in-the-money premium time value as less a factor and holders of in-the-money options who wish to close out their positions will usually discount the time value to attract buyers.

There are ways to profit from out-of-the money options. For example, Credit spreads (one type is a spread between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating) can offer a trader a profit if they expire out of the money. The time premium (net options value) that a trader collects when establishing a spread will fall to zero if the spread remains out of the money upon expiration. The premium initially collected is thus retained as profit. Another potential happy camper is the writer of covered calls when they see the time premium portion of the option go lower as this improves the probability that their underlying stock won't be called away and they can keep the premiums they've received and the stock they had pledged; win-win. Without a doubt, in the world of options, "time is money".