Time value has one basic characteristic that it is ever depreciating. Meaning comes what may, a part of premium would reduce everyday attributed by the time value decay.

It makes sense every once in a while, to go back to basics to sharpen the trading skills. We will make that attempt today by revisiting the element of time value in the options. As we all know, besides the complex math there is a rather simple bifurcation of option premium.

Option Premium = Intrinsic Value + time value

Where intrinsic value denotes an amount of money already built in the option price. All the lower calls/higher puts give an option to buy lower and sell higher. The amount by which they give an option to buy lower/sell higher as against the underlying price is called intrinsic value.

Example: 10500 Call @ 350 with the underlying index trading at 10800 is holding an intrinsic value of 300.

Now the time value is nothing but premium – Intrinsic Value i.e. 350 -300 = 50.

For obvious reasons intrinsic value prevails only in lower calls & higher puts, time value is prevalent across the strikes.

Now this time value has one basic characteristic that it is ever depreciating. Meaning comes what may, a part of premium would reduce everyday attributed by the time value decay.

We will try and analyse the decay a little further and conclude with the action plan to deal with it effectively so that it does not disturb our profitability while trading direction.

Suppose 10,000 strike call is trading at 230 with 20 days to expiry, the following chart will explain the daily decay in time value given an underlying price and Rik remains constant in the market.

Note: Every reading denotes an amount of value in premium that will be lost over a day, keeping other things constant. Please note the negative value of decay with 19 days to expiry & just 1 day to expiry.

Observation: Time value decay increases with each passing day and is highest close to expiry.

Action Plan:

> Choose your option trade based on current point in time in expiry

> To hold the option for a longer time, have a simultaneous short option in place to handle the time decay over your trade horizon

> While single option would work well in the beginning, we may need to sell one or even two options against every option bought as we get closer to expiry

While this plan lays out the rule of thumb, in practice I would like to share my choices where for the same trade of a 4 -5 session horizon 1st week of expiry, I prefer trading with single option.

The second and third week though advocates trading the same horizon with a directional view using spreads meaning buy one call/put and sell a higher call/lower put at the same time. This would restrict the profits at the sold strike level & compromise the profit in between but eventually turns out to be more effective than single bought option.

Lastly, for the week of expiry, I do use ratios by buying a call/put and selling 2 higher calls/lower puts. But, be careful in strike selection and maintain a distance between strikes bought & sold as there is a possibility of losing a lot if the stock moves beyond target too fast.

Thus, appreciating the difference in behaviour of time value across expiry and modifying the option trade helps optimising pay-off from option trading.

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