SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.
  • Get smarter and more educated about the nuances and risk of trading from others like you.
  • Helps professional traders see their blind spots.
  • Have access to resources and be a resource to other traders.
  • Get quick responses from the SteadyOptions team.
Sign in to follow this  
Followers 0

Options Expiration Date And How It Influences The Price


To understand how the expiration date of an option influences the price, one first needs to understand how the price of an option is calculated in the first place. While the standard formula to calculate options prices, the Black-Scholes model, is very complex and requires advanced knowledge of statistics, for most traders it is sufficient to understand the basics involved.

Elements of the price of an option

 

When someone who is options trading buys or sells an option, the price of it is determined by a few factors.

These are:

  • The intrinsic value of the option.
  • Plus: the extrinsic value, which depends on:
  • The time to expiration.
  • The risk-free interest rate.
  • Volatility.
  • Dividends.

 

Only ITM options have intrinsic value. Let us assume the share price of company ABC is currently 100USD. A call option with a strike price of $80 will have an intrinsic value of $20.

 

If that option sells for $24, therefore, the intrinsic value is $20 and the rest ($4) is extrinsic value, of which time value, determined by the time to expiration, is an important component.

 

Time value

 

If one looks at a typical options chain, it is immediately clear that the more time there is until expiration, the more expensive the options become. The newer 1-week options are, everything else being equal, much cheaper than 1-month options, which are in turn much cheaper than 3-month options.

 

This is simply because with more time to expiration the price of the underlying asset has more scope to move up or down. The options writer needs to be compensated for this risk, otherwise there is little sense in writing (selling) an option.

 

Time decay

 

When a trader therefore buys a call or put option, a certain percentage of the purchase price is for time value, i.e. to compensate the options writer for the risk he is taking during the time left to expiration.

 

What is vital to understand here is that the closer to expiration the options come, the less time value they will have. Even if the price of the underlying asset does not move a single cent, your call or put option will lose its time value component as the expiration date approaches and eventually it will expire worthless. This is referred to as the time decay of options.

 

For options buyers time decay is their biggest enemy. The price of the underlying has to move beyond the strike price of their options by the expiration day, or they will become worthless. For options sellers this often becomes their best friend: all they need is for the underlying price to remain on the ‘right’ side of the strike price long enough and they will keep the full options premium.

 

What is interesting to note here is that options tend to suffer more time decay during the last 30 days of their lifetime than during earlier months. This is why many options sellers only sell options with an expiration date that is no more than 30 days away. Options buyers, on the other hand, need as much time as possible to give their options an opportunity to reach their strike price.

Summary

 

It is important to understand how time to expiration influences the value of options. An option buyer is literally ‘buying time’ when he or she purchases longer term options, while an options seller will get bigger premiums for a longer term option than for a short term one, but this means additional risk because there is more time left for things to go wrong.

 

This article presented by Marcus Holland, the editor of FinancialTrading.com – a new but fast growing education resource on all aspects of financial trading

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional market neutral strategies for active traders

10-15 trade ideas per month

Targets 5-7% monthly net return

Visit our Education Center

Recent Articles

Articles

  • Trade Size: Taming The 800-Pound Gorilla

    I often refer to selecting a proper position size as the easiest and most important risk-management technique for the individual trader. It is always tempting to trade bigger size, especially when confident. Big size can produce big profits. Traders believe that earning bigger profits is the path to wealth.

    By MarkWolfinger,

    • 0 comments
    • 49 views
  • Best Trading Articles 09/24/16

    Reading as much as we can about trading always helps us to improve and become better traders. I'm pleased to share some of the best trading articles, podcasts and videos from some of my favorite traders, bloggers and educators. If you came across an interesting article please share it in the comments section.

    By Kim,

    • 0 comments
    • 347 views
  • Probability vs. Certainty Trap

    We all would like all our trades to be winners, but we know this is not possible. We know some of the trades will be losers. Many traders think that if a trade has lost money, it was a bad trade. They try to identify what errors they made that lead to losses. Why? "Because I lost money! So surely I have made a mistake somewhere?”

    By Kim,

    • 0 comments
    • 164 views
  • Should You Care About The Sharpe Ratio?

    The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such calculations. It was developed by Nobel laureate William F. Sharpe. The Sharpe Ratio is the annualized return of an investment earned in excess of the risk free rate divided by the investment's annualized volatility.

    By Jesse,

    • 0 comments
    • 532 views
  • 10 Options Trading Myths Debunked

    There are a lot of myths and misconceptions about options trading. Many traders refrain from trading options because they consider it too risky. The only dangerous part of options trading is the risk-insensitive trader who buys and sells options with little or no understanding of just what can go wrong.

    By Kim,

    • 0 comments
    • 242 views
  • Adaptability And Discipline

    Whenever we talk about discipline, everyone seems to understand that we are referring to trade decisions. We know that good discipline is required to pull the trigger and exit a trade with a loss. It really should not be difficult. After all, we know our position has not been working and is not likely to get better any time soon.

    By MarkWolfinger,

    • 0 comments
    • 208 views
  • Best Trading Articles 09/17/16

    Reading as much as we can about trading always helps us to improve and become better traders. I'm pleased to share some of the best trading articles, podcasts and videos from some of my favorite traders, bloggers and educators. If you came across an interesting article please share it in the comments section.

    By Kim,

    • 0 comments
    • 256 views
  • Uncovering the Covered Call

    For most option traders their first encounter with options was probably Covered Calls. Covered Calls are easy to understand, seem to have very little risk and convey the feeling of being more than just a “plain investor”. They are still the most popular option strategy.

    By Reelken,

    • 8 comments
    • 713 views
  • 3 Words You Won't Hear On CNBC

    The future and markets are unpredictable. When asked on CNBC to make any predictions or forecasts about the future or the markets, the ONLY correct answer is: I DON'T KNOW. Of course nobody has the courage to say those three words on CNBC or other financial media, otherwise they would never be invited back. 

    By Kim,

    • 0 comments
    • 360 views
  • Are The Markets Rigged?

    "Since the beginning of the financial markets, trading has undergone constant changes. High frequency trading, rigged markets, unexpected news and insider trading makes profitable trading impossible for the regular trader. But is that really true, and is trading becoming harder and harder these days?"

    By Kim,

    • 0 comments
    • 318 views

jig likes this
Sign in to follow this  
Followers 0


User Feedback


There are no comments to display.



Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   You have pasted content with formatting.   Remove formatting

×   Your link has been automatically embedded.   Display as a link instead

Loading...