Time decay is the decline in the value of an option just before it expires. Investors must be aware of the incidence and rate of decline to respond accordingly. The main risk is with long options, while short options can benefit from falling time.
Time decay refers to the process that takes place when the value of an option or options experiences a period of decline. This change in the option price is generally attributable to an identifiable set of circumstances and occurs just before the end of the option’s useful life. Investors tend to be on the lookout for signs that time decay is about to occur. Accurate measurement of incidence and rate of decline over time allows action to be taken to respond accordingly.
It is 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 hits the expiration date. Many investors understand this and don’t see it as a cause for alarm. Often the option will suffer a short period of decline and then recover towards the end of the period. However, when the decline continues, the option is in a state of temporary decay and the investor has to determine whether or not to sell the option.
Knowing the right time to sell when the weather decline becomes apparent can be tricky. Too often, investors choose to wait a little longer than necessary, anticipating that the decline will level off. One of the best ways to properly identify the time drop and sell the option before price erosion reduces the return on investment is to look at the reasons for the option price drop. 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 falling time has to do with long options. Attention to the performance of the last thirty to forty-five days is essential to avoid incurring a loss with the option. At the same time, a short option that is affected by falling weather can be a very good thing for the investor. The decrease in the value of the related long options could actually help increase the price of the short options and make the investment more profitable than it otherwise would have been.
Smart Asset.
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