Putting Time Decay to Work in Your Favor

Time decay is one of the most fundamental concepts in trading options. It’s one of the first things we learn when we’re starting out.

Whichever side of the trade we’re on – buying or selling an option – we know that time is constantly ticking away. After all, options expire. And their value erodes as you get closer to the expiration date.

For a buyer, the longer it takes for a move to play out, the less likely their chance of success.

Because time decay doesn’t happen in a straight line – it accelerates the closer it gets to the option’s expiry.

So, late in the option’s life, even a big move might not be enough to recover your position.

That’s why some traders prefer to use option-selling strategies instead. By selling an option, you can make time decay work in your favor…

Which Option to Write?

Selling an option enables you to capture time decay. But it’s not always clear which option you should write.

An option’s strike price is an important piece of the puzzle. The option’s strike price is the price at which the option buyer can exercise the option. For example, if you sell a call option at $50, you must hand over your shares at $50 if the buyer exercises the option.

So let’s consider one of the most popular option writing strategies to learn how to pick which option to sell.

A “covered call” is where you write call options over shares you own to generate income. (Note that you have to own 100 shares for each contract you sell. It can be very dangerous to sell options if you don’t own the shares.)

If you’re writing an option that is a long way out-of-the-money (OTM) – that is, the option’s strike price is a long way above the current share price – then there is little chance of the option being exercised. That can be a positive if you want to keep your shares long term.

The downside is that you’ll likely generate very little income. The further you move away from the current stock price, the less valuable the option becomes.

On the other hand, if you write a call option that’s in-the-money (ITM) – that is, the call option’s strike price is below the stock price – you’ll generate far more premium income. The option will have both intrinsic value and time value.

The obvious downside is that you have a much greater chance of the option being exercised. That can lock you into selling your shares below the market price. The further an option is ITM, the higher the chance of exercise becomes.

That’s why you’d only likely consider this ITM strategy if you thought that your shares might be about to go through a retracement in the short term (but you still want to keep them in the long term).

So what’s the right answer?

Maximize Time Decay

The best way to capture the most time value is to write your call options as close to the money as you can…

An at-the-money (ATM) option can help you maximize profit while allowing you some wriggle room to lessen the chance of being exercised.

If you’re neutral to slightly bullish on your shares (and you want to own them long term), then you’d look to write your call options slightly above the current price.

So, for example, if a stock is trading around $100 and you think the maximum price it will reach within the option’s life is $105, then you might write calls with a $110 or $115 strike price.

You’d only write the options exactly ATM (at $100) if you were convinced that the stock had already peaked and would drift lower within the option’s life.

So the trick is to find the right balance between generating income and the likelihood of your option being exercised.

And if you get it right, accelerating time decay works in your favor.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict

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