Time decay is the decline in the value of an option just before its expiration date. Investors need to identify the signs of time decay and sell the option before the decline continues. Examining the reasons for the decline can help determine whether to sell or hold on. Long options are at risk, while short options can be profitable.
Time decay refers to the process that takes place when the value of one or more options experiences a period of decline. This change in the option price is usually attributable to an identifiable set of circumstances and occurs just prior to the end of the option’s life. Investors tend to be looking for signs that time decay is about to occur. Accurately measuring incidence and time decay rate allows you to take steps to respond accordingly.
It’s not unusual for an option to perform very well for most of its life, but start to change slightly in value a month or two before it reaches its expiration date. Many investors understand this and don’t see it as a cause for alarm. Often, the option will go down for a short period and then rise towards the end of the period. However, when the decline continues, the option is in a time decay state and the investor must determine whether or not to sell the option.
Knowing the right time to sell when time decay becomes apparent can be tricky. Too often, investors choose to hold on a little longer than necessary, anticipating that the decline will subside. One of the best ways to correctly identify time decay and sell your option before price erosion reduces your return on investment is to examine the reasons for the option price decline. If the underlying causes of the decline are due to circumstances that are likely to remain in place for an extended period of time, the investor would do well to sell as soon as possible.
It is important to note that the main risk with time decay has to do with long options. Paying attention to the performance of the last thirty to forty five days is crucial to avoid incurring losses with the option. At the same time, a short option that is affected by time decay can be a very good thing for the investor. The decrease in the value of related long options could actually help increase the price of options over short options and make the investment more profitable than it otherwise would have been.
Smart Asset.
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