In this article, we will discuss:
- How to mitigate the effects of time value decay.
- Understand the relationship between intrinsic value and time value
Also, recall that:
- Call option intrinsic value = Stock price – Exercise price
- Call option Time Value = Call option price – Intrinsic Value
- The minimum value of intrinsic value is 0.
Time Value Consideration
Time value decay is always a consideration to make for option buyers. Due to time value decay, the price of an option will decrease over time while keeping other factors constant. There are several ways to mitigate the effects of time value decay.
Buy short-term deep in the money options
Deep in the money call or put options have lots of intrinsic value but little to no time value. This is a characteristic of options which are deep in the money. For deep in the money options, the intrinsic value as a percentage of the option premium outweighs the time value as a percentage of option premium.
Sell options as adjustments to long positions
A long call position will be subject to much time value decay as it approaches expiry. As an example, the trader could sell a higher strike call option to convert the trade into a bull call spread. While this limits the upside of the long call position, the effect is that time value is mitigated to a certain extent here. While the long position loses on time value decay, the short position gains on time value decay. Similar adjustments can be made to long put positions by selling a lower strike put option, converting the trade into a bear put spread. Hence, an options trader can always make adjustments to a trade to mitigate time value decay by selling options which are complementary to the existing trade.
Close any long ATM or OTM options with 30 days left to expiration
OTM options ands ATM options have no intrinsic value. The time value makes up the entire option premium. Since time decay occurs at the fastest rate over the last 30 days or so, time value will decrease exponentially over the last 30 days. A trader who holds on to such an option will experience drastic declines in the option premium with all things being equal. Hence, traders should sell off any long ATM or OTM options with less than 30 days to expiration.
<Insert time value decay chart>
The table shown below is a snapshot of call options in ascending strike prices(option series) for a particular stock. The price of the stock is trading at $42.5.
|Call option||Last($)||Intrinsic value||Intrinsic Value as a % of option price||Time Value||Time Value as a % of option price|
Let us examine the Jan 12.5 call option. The price of the underlying security is $42.50. Hence, the intrinsic value of Jan 12.5 call is $42.5 – $12.5 = $30 . The time value is thus the option price less the intrinsic value. $30.50 – $30 = $0.50 . As you can see, the time value only makes up approximately 1.7% of the total option premium of $30.50. This is an example where deep ITM options have very little to no time value.
If we move higher up in terms of strike price, you will start to see a trend where the time value as a percentage of the option price becomes larger. Let us examine the Jan 40 call. The intrinsic value is $2.50 while the time value is $3.75. Here, time value makes up a large portion of the option price of $6.25. The conclusion is this: Deep In-The-Money options have little to no time value. The deeper it is in the money, the less time value an option has. Hence, buying deep ITM options is one of the ways to combat the effects of time decay. After all, if there is so little time value left in a deep ITM option, how much time value decay can occur? The answer: Not very much.