Benefit from Time Decay in Selling Options
We prove again and again that the selling of options is very beneficial. In selling options we encounter the same elements that affect the options premium as when we buy the option.
The components are, time untill the options expire, volatility and the strike price, and time decay. Let us discuss each part and how you can benefit from it.
The strike price. The more strike price goes away from the current market price the less likely it is that the underlying will reach that strike, the lower is the price that the market is willing to pay us. Quite simply: a higher risk results in a higher premium. And the smaller the risk means a lower premium.
Volatilty is the next element to determine the premium of an option. The more volatilite the underlying is the higher premium we receive. This is an excellen condition to sell options premium. We prefer to sell options with high Implied Volatility, they have the most option premium. And when IV drops we can take of the risk of the table and buy back the options for a lower price.
In a low volatility period, it is less convenient to sell options. A low volatility indicates prices does not move much and the markets are less nervous.
If you want to find out if the market is nervous you look to the VIX. The VIX is an index that measures implied volatility in the price of options.
An increase of the S&P500 corresponds a decrease in volatility, of the VIX. On the contrary, to a decrease of the US index, we see a rise of the VIX. The VIX is also known as the “index of fear”.
With the sale of options, we reverse the positive and negative aspects that we saw with the purchase. Now, time and probability are on our side.
The second element that affects the option premium is the expiration date. The further away the expiration date is the more premium the option will have. Options near expiration are less expensive, the chances that the market does not reach our strike, are greater than expiration and so the market pays us a smaller premium. Time in selling options is our valuable ally.
Time decay is our best friend. Every day that passes, the option we sold loses a small part of its value. Especially, over the last 45 days.
When you buy an option the price of the underlying has to move fast en long enough in the desired direction.
We can also see the underlying moves a little bit up. This results in a decrease in volatility, what means that the sold option loses value.
We benefit from options because of Time Decay. Time decay is represented by a Greek term know as Theta. Theta is a important component for options traders that decide to sell options. They will receive options premium to take on risk. And the out of the money option will loose money when time passes. We will choose options with high implied volatility. These options do have much option premium. Read also the post using positive theta strategies