I probably can’t preach this enough but fully understanding the Time Value of Options is one of the most important factors when trying to determine your trading strategy. With stocks it’s fairly easy. If you think the stock is going higher then buy the stock. You could hold the stock for 2 days or 2 months before it gets to your target but you don’t care with regular stocks.
With options we have another question to ask: How long will it take to get to our target? Now we not only have to be right in our directional analysis but also on the timing. Virtually impossible which is why we favor option selling strategies.
Time Decay Refresher
Time decay is the amount by which the price of a stock option exceeds its intrinsic value. Generally time decay is represented by the Greek Theta. The greater the time until expiration, the greater the time value (see the graph below). What some people don’t understand is that Theta also takes into account interest rates, dividends, the price of the stock and the expected volatility of the stock. All of these are factors you have to consider when making your next trade.
OTM Option vs. ITM Option Time Decay
For OTM options (out of the money options), the entire value of the options the the time decay premium. But for ITM options (in the money options), once the stock is ITM it starts picking up intrinsic value and the time value component decreases. Beginning traders often view at the money stock options as being expensive because they blindly assume that they have high levels of time decay or Theta. This is not accurate.
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