Making profits with options is an exciting proposition for most traders. Trading with the right options can give you handsome profits at a very low cost. However, there is one risk in options trading that many options traders miss. Unfortunately ignoring this risk can be a deadly mistake. It can not only cause unnecessary losses but can even deplete the entire option premium completely.

If you have already guessed it, we are talking about the time value of options. If you want to trade better, then you will have to understand what time value is, and how it affects every options trader, either in or positively or negatively.

How does passage of time affect option premium?

 As you know, option premium is made of two components: intrinsic value and time value

 Option premium = intrinsic value + time value

Iintrinsic value represents the difference between the price of the underlying asset and the strike price of the option. It is easy to calculate since it just involves tracking the movement of the underline and then making a small calculation to arrive at the intrinsic value.

Time value, on the other hand, represents the extra amount that the options trader is willing to pay for buying the option, over and above the intrinsic value.

In simple terms, you can calculate time value with the following formula:

Time value = option premium – the intrinsic value of the option.

For an option buyer, the time value is a cost. This is because time value gradually decreases with time and becomes zero at the time of expiry of options. So this is a definite loss for the option by since even if he pays Re. 1 as the time value, he is certain that it will become zero on expiry. Hence he is definitely going to lose Re. 1. So the increase in the intrinsic value of the option should be at least Re. 1 to at least recover this reduction in time value and make him reach break even.

Does the time value become zero overnight?

The answer is no. The time value gradually reduces the life of the contract and becomes zero only upon expiry. So the time value can only become zero overnight if you buy the option just one day before expiry.

At what rate does the decay in time value happen?

The decay in time value happens at a slower rate when the expiry is far away. However, as the option approaches expiry the rate of decay in time value accelerates and the option loses time value faster.

Theta is a statistical measure (Option Greek) which enables us to measure the rate at which the decay in time value will happen. It is measured as the value of Theta lies between 0 and the total value of the option for both calls and puts.

As mentioned earlier, the value of theta increases as the option approaches expiry. For example, at the beginning of the life of the option, the theta can be as low as Re. 0.50, this can easily increase to Re 2.00 just a few days before expiry.

How options traders can use the time value

Option buyers and sellers get affected by time value in two entirely different ways. While time value works in favor of the option sellers, it causes losses to the option buyers.

l  Option buyers: The decay in time value works against the option buyers as it causes the premium of the option that they have bought to come down. This is like a ticking time bomb. If they buy the option just a few days before expiry, the time value will decrease alarmingly fast and the increase in the intrinsic value should happen at an even faster rate to compensate for the decline in time value.

However, it is seen that buying options that have an expiry many weeks away is much safer for them. As mentioned earlier the decay in time value happens at a slower rate when the expiry day is far away. Hence they lose a lesser amount of time value per day and also get ample time till expiry for the intrinsic value to increase.

l  Option sellers: For option sellers the decay in time value is favourable. The loss that the option buyers incur due to a decay in time value, becomes a profit for the sellers. Hence many option sellers sell deep out of the money options to make risk-free profits. In such a case the option has very little chance to become in-the-money and the seller gets to retain the premium that he has received by selling the deep out-of-the-money option.

If you are planning to trade in options, then you need to keep a close eye on the time value of the option. If you are planning to buy the option, then try to pay as little time value as possible, since you can be sure that whatever time value you pay will ultimately vanish over time. If you are planning to sell options then try to get as much time value as possible since it will give you a cushion against possible losses happening due to an increase in the intrinsic value, which can make the option profitable for the buyer.