Options are wasting assets. That is, the longer you keep a long option position, the more you are likely to lose. This is one of the reasons why many prefer to trade futures. In this article, we discuss why options are wasting assets and how that impacts your trading.
Intrinsic value versus time decay
An in-the-money (ITM) option carries both intrinsic value and time value whereas at-the-money (ATM) and out-of-the-money (OTM) options have only time value. The time value of an option becomes zero at expiry. This means all options (ITM, ATM and OTM) must lose some value every day during their life. That is why options are referred to as wasting assets.
Suppose you buy the next-week expiry 16300 call option on the Nifty Index at 89 points. This call is OTM with the spot index at 16258. So, the option premium consists of only time value. What if the Nifty Index moves to 16300 three days after you buy 16300 call? The price would be 88 points assuming volatility remains unchanged. That is, despite a 42-point movement in three days, the option would have hardly moved. If the index takes another day to each 16300, the option would be worth only 80 points.
What if the index moves to 16400 (142 points) with six more days to maturity? The option may increase by only 61 points to 150. Why? The intrinsic value of the option is 100 points. This can be determined by deducting the strike price (16300) from the spot price (16400). Note that the intrinsic value of an option will move one to one with the spot price. But the decay (loss) in time value will drag down the option price, resulting in the total price increasing by less than the change in intrinsic value (price increasing from 89 to 150 and not to 189).
But the speed of time decay can sometimes slow down. How? Suppose the implied volatility of the 16300 call increases by two percentage points. Then the movement in the Nifty Index to 16400 with six days to maturity will result in option value of 165 points. Note the 15-point jump in value because of the increase in volatility.
The above discussion shows two important observations. One, when an ATM option becomes ITM, the price will not change by the same magnitude as its intrinsic value because time decay will drag down the option price. And two, speed at which time value decays can slow down when implied volatility increases.
How should you apply these observations in trading? For one, you should not hold an option position for a long time. If an option is struggling to become ITM, you should close your position and cut losses. For another, betting on implied volatility could help reduce the speed of time decay.
Optional reading
The time value of an option is determined by backing out intrinsic value from the option price. The time value of an option consists of time to maturity and implied volatility. When implied volatility increases (explodes), the speed of time decay will reduce. On the other hand, when implied volatility decreases (implodes), the speed of time decay increases.
Note that an increase in demand for a strike leads to increase in implied volatility; decrease in demand leads to decline in implied volatility. As an option approaches expiry, its demand reduces because traders switch to next-week expiry for Nifty options and next-month expiry for equity options. Therefore, both implied volatility and time to maturity contribute to time decay, thereby accelerating the decline in option value. You can take advantage of this by shorting options during the expiry week, depending on your view on the underlying. For instance, shorting puts when the underlying has a marginal upside bias and shorting calls when the underlying has a marginal downside bias.
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