As an option gets closer to expiration, it losses value. So by selling options, everyday that goes by, makes your trade more profitable. I call it Selling Time.
Have you ever heard the song, Time is On My Side by The Rolling Stones?
If yes, then you know what it feels like to be an option seller. Everyday that goes by, the options I sell lose value.
Let's use an example:
ABC stock is at $80. I sell you an option that expires in 30 days that allows you to buy ABC at $100 ($100 is the strike price of the option.). I charge you $1 for this option.
Now each option controls 100 shares, so this option worth $1 actually costs you $100. The only way you will make money is if ABC goes above $101 ($100 plus the $1 cost of the option) within 30 days. If ABC stays below $101, I make money.
The clock is ticking. Tick tock. Time is on my side. By the way, even though the markets are closed Saturdays, Sundays, and Holidays, options still lose value on those days. So the 30 days until expiration is 30 calendar days, not 30 trading days. Cool huh?
The seller of an option attempts to benefit from the decay of the option's time value. Time value captures the possibility, that the option may increase in value due to the changing value of the underlying stock. This value depends on the time until the expiration date and the volatility of the underlying stock's price.
If the underlying stock's price has not been reached by the strike price of the option, the option is considered to be out of the money. As time passes, if the option remains out of the money, the option gradually loses its time value.
The time value of an option is always positive and declines exponentially with time, reaching zero at the expiration date. Upon expiration, if the option is still out of the money, the option will have no value left, and it will expire worthless. Its holder will simply abandon the option leaving the option seller with the premium. (Premium is jargon for amount paid for the option.)
The entire premium for which I sold the option will be in your account, less commissions and fees. At that time, your position closes out automatically.
The graph above illustrates the accelerated decline of time value as expiration draws near. The graph allows you to see why an option is considered a "wasting asset". Time value erodes as each day passes. The rate at which the time value is eroding increases as the option's expiration nears. Notice that the time value decays the fastest during the last days of the option's life.
Notice how the option loses value fastest in the last 30 days. Because of this, we sell options no longer than 50 days left to expiration. We want our options to expire 50 days from now or sooner. The amount depends on the strategy used. Sometimes we can make 20% in a couple weeks, other times we make 10% in 40 days. It depends on the market and strategy used. But it is best to sell options 60 days or less to expiration to get as high a theta as possible. Theta is jargon for the amount an option loses value each day. So if an option has a theta of 10, that means that option will decline in value $10 each day.
In many cases, we don't even need to wait until the option expires to get out of the trade. Let's say we sell an option for $1, and 21 days later the option is worth 10 cents. We just made 90 cents. We should just buy back the option we sold for 10 cents and move on to the next trade. Even though we can make another 10 cents, it might not be worth it. We might find another trade that we can better use our money for. Getting out also locks in our profit.
So let's say we do a trade that has a maximum return of 12% in 50 days. If after 30 days we are up 9% it might be best to take the money and run. Instead of making another 3% in 20 days, we can probably find another trade that can generate a better return in the same amount of time.
In our next lesson we are going to learn how to trade options on a stock whether it goes up, down, or sideways.
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