Options Trading 101: Too Much Time Decay On My Hands

“Too much time on my hands? It’s ticking away with my sanity

I’ve got too much time on my hands It’s hard to believe such a calamity I’ve got too much time on my hands”

–Styx, Too Much Time On My Hands

It is probably safe to make a handful of assumptions amid the most peculiar times most of us have and, hopefully, will ever live through.

One – large numbers of Americans are either unemployed, facing reduced income, or fear one of these fates in the near future.

Two – this reality has prompted many Americans to take a close look at their finances, ranging from day-to-day budgets to investment accounts.

Three – large numbers of Americans have a ton more time on their hands today than they did in, say, early March.

Four – with all of this time, many Americans are finding finance-related platforms, including SteadyDime.

Five – a significant chunk of these people wonder if day trading or some other form of stock or option trading could make sense for them. Heck, if I am home all day with nothing to do, I might as well roll the dice and make some cash.

Six – many Americans have no idea how to proceed and require guidance. That guidance should always start with the basics and a little bit more.

So Your Pandemic Response Is To Learn Options Trading

This is a great idea. It really is. Moreover, there is a decent chance you found this article by searching for information on how to trade stocks or options. Before you start trading, you absolutely need to ensure you have your personal finance ducks in a row. We cover the critical components of getting this done elsewhere on Steady Dime:

What A Pandemic Can Teach You About Trading

3 Things You Need To Start Trading Options

3 Things That Will Make You A Better Options Trader

Furthermore, we cover the basic strategies that every would-be options trader should start with.

Effectively, the strategies outlined in G etting Started With Options Trading serve several

functions. Maybe most importantly, they help people new to options get comfortable with the basics as well as few ins and outs. They also serve practical purposes for you as an investor.

For example, traders, particularly those with time horizons longer than a few minutes or days, can effectively use strategies such as writing covered calls and selling puts to see how these instruments function. To see how they move in relation to time and the underlying equity in association with a relatively less risky longer-term investment strategy. When you write a covered call, you can do it alongside a long position in the underlying equity as a way to generate income. So, as a beginner, it’s a great strategy to get comfortable with options while also bringing in some income on top of your portfolio. Additionally put selling on blue-chip names in a cash portfolio is another way to learn the nuances of options and earn money.

The four links mentioned above provide a fantastic primer for people looking to get into options, specifically the finer aspects of trading options. Those links should be required reading, but there are other factors to consider, mainly if all of the time you have on your hands has brought you to the point of being curious (or more) about options.

Time Decay

Right after you not only know the basics but check everything off of the basics list (as in, you have done the things you need to do before and right when you dig into options), you need to study time decay. Time decay might be the most important concept you’ll ever learn as an options trader – short-term, long-term, and any duration in between. If you don’t know it, you will fail. Pure and simple.

Investopedia provides a helpful explanation of time decay:

Time decay is a measure of the rate of decline in the value of an options contract due to the passage of time. Time decay accelerates as an option’s time to expiration draws closer since there’s less time to realize a profit from the trade…

Time decay is the reduction in the value of an option as the time to the expiration date approaches. An option’s time value is how much time plays into the value—or the premium—for the option. The time value declines or time decay accelerates as the expiration date gets closer because there’s less time for an investor to earn a profit from the option.

If you pay attention, time decay is a pretty straightforward concept. Look at it this way, using a somewhat unrealistic example just so the numbers and idea can be crystal clear.

Trader Vic buys a September 2020 call option with a strike price of $40 and a $6.00 premium. Vic believes the underlying stock, trading at $38.50, will be at $46 or higher at options expiration.

Trader Joe buys a call option at the same $40 strike price, but it expires in one week (a weekly option, maybe), just one month away, as of writing this article. The option premium is only $0.40.

Joe paid much less for his option contract because it is much less likely that the stock will move enough to hit his breakeven, whereas Vic has a much better chance of seeing this happen.

Time is on Vic’s side, while it’s working against Joe. It’s all quite self-explanatory to anyone with basic math and planning skills.

However, for some reason, it’s not always that simple in practice. I don’t think the reason comes down to anything technical or specific to options trading. Instead, I call it a function of human nature.

Humans tend to get excited about something and, in that emotional journey, lose sight of the process and closing the deal. It’s like you’re enamored with your girlfriend and the text message she sent you as you’re driving to her house. So you’re staring at your phone on the ride over, you rear-end someone, total your car, and don’t get to see your girlfriend after all. This is akin to entering an options position that immediately goes well and shows an on-paper profit. You get caught up in this emotional victory, losing sight of the fact that time decay can, seemingly overnight, impact your position negatively.

Bottom line: Time decay can sneak up on you. Fast. You’ll see its most aggressive effects the closer you get to your contract’s expiration date.

Action item: Before you make a trade where time decay will be a factor, make about 20 simulated trades to see how time decay acts on the ground. At the very least, seek out simulated models. This one from the Options Industry Council (OIC) is better than most and will help you understand and properly react to the effects of time decay on your options trades and positions.

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