Has anyone ever told you that 80% or more of options expire worthless? Since options have expiration dates and eventually expire, they lose value over time. If held to the expiration, an option contract could easily expire worthless. That's why some people call them "wasting assets." So, if most options expire worthless and they lose value over time, why in the world would anyone buy a put or a call?
The idea that most options expire worthless is false. According to a comprehensive study from the International Securities Exchange (ISE), which included more than thirty years of data, only 30% of options expire worthless. About 10% are exercised and the remaining 60% are closed through offsetting transactions (statistics presented in 2004 by Alex Jacobson, Vice President, International Securities Exchange.) Indeed, it is much more likely that an options contract will be closed out through an offsetting transaction than allowed to expire worthless at the expiration.
Still, options are wasting assets and any time an option contract is bought, the investor is battling the impact of time decay. Importantly, time erosion is non-linear, which means that short-term options lose value at a faster rate than longer-term options. Consequently, for an options buyer, one way to mitigate the impact the negative impact of time decay is to focus on longer-term rather than short-term options.
Say, for instance, you want to buy a straddle (puts and calls) in mid-September because you think the stock will make a big move over the next few weeks. It is probably better to buy the January rather than October straddle. The October straddle, which would expire in four weeks, will see a faster rate of time decay than the January straddle, which expires in several months.
To illustrate, Biogen Idec (BIIB) - Get Reportshares are trading around $55.50 and the strategist expects a big move from now through the October expiration but is ensure about direction. One option is the October 55 straddle at $3.35 (see graphic below, prices as of Friday's close). Or, she might buy the January 55 straddle at $8.60. The October 55 straddle is a lot cheaper because there is much less time value embedded in those two options.
Biogen Idec (BIIB)
However, looking at theta, we see the time value lost per day in the October straddle is more than double that of the January straddle. Theta is the Greek that measures the impact of time erosion on a position. Specifically, it measures the estimated value lost in cents per day. If an option has a theta of -.01, it loses $0.01 per day due to time decay. In short, it is normally better to avoid the front-month options when buying straddles because of the negative impact from time decay. Theta decay will affect both sides (the puts and calls) of the trade.
There are other ways to mitigate the risk from time decay. For example, instead of buying calls, you might consider buying call spreads: i.e. buying a call and selling a call at a higher strike. There are also ways to profit from time decay including strategies like covered calls, calendar spreads and butterflies. In other words, just because options are wasting assets, doesn't mean they're stupid investments. The key is to understand the product and understand the risks. Then, identify the best strategy that matches your outlook for the stock, industry group, or market.
See you Wednesday!
At the time of publication, Fred Ruffy held no positions in the stocks or issues mentioned.
Frederic Ruffy is an experienced trader and provides daily commentary and analysis of the options market. He is co-founder of the web site, WhatsTrading.com. His work has also appeared in Futures Magazine, Technical Analysis of Stocks & Commodities, Stock Futures and Options, and Sentiment.
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