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Time value is an important factor in options trading. If you intend to take a long option position, you must not pay too much for time value. This is because time value of an option becomes zero at expiry. If you want to set up a short option position, time decay or the loss in time value as the option approaches expiry contributes to your trading gains. This week, we discuss the trade-off you face with time decay when you set up short option position.
The trade-off
The near-week 18000 Nifty call trades at 28 points whereas the next-week 18000 Nifty call trades at 91 points with the Nifty Index at 17924. When you are intending to short Nifty calls, you must decide whether to trade the near-week contract or the next-week contract. At first glance, this choice may seem obvious. The time value for the next-week contract is greater than this week. So, if you want to capture gains from time decay, an option with greater time value at the time of initiating the short position ought to be better.
The point is that the time decay of the near-week option is faster than the time decay of the next-week option. For instance, the time decay of the 18000 near-week call is 26 and the next-week call is 8.5. This means if the Nifty Index remains at the same level and other factors driving option price such as interest rate and volatility do not change, the near-week contract will lose 26 points tomorrow just because of passage of time whereas the next-week contract will lose only 8.5 points.
You should typically prefer the near-week contract as your objective is to capture gains from time decay as quickly as possible. Time value is a function of time to expiry and implied volatility of an option. Shorter the time to expiry, faster the decay in time value. And greater the implied volatility, greater the time decay if implied volatility declines as the option approaches expiry.
Now, time value is a function of an option price and its location in relation to the underlying price. That is, if an option is in-the-money (ITM), then time value is the difference between the option price and its intrinsic value. If the option is at-the-money (ATM) or out-of-the-money (OTM), then the option price has only time value. Also, higher demand for a strike typically leads to increase in price translating into greater time value. That means more gains to capture from time decay. This is especially true for the ATM and immediate OTM options.
Optional reading
Whether you choose a near-week or the next-week option, it is important to short the strike that has the highest vega within the expiry series; for, vega captures the loss in option price for a one-point decline in implied volatility. This is important because decline in implied volatility leads to faster time decay with higher vega accelerating the decay.
The author offers training programmes for individuals to manage their personal investments
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