Let's Talk About: Time Decay
TIME DECAY BASICS
Whenyou buy a call, you pay a premium for the right, but not theobligation, to buy a particular stock at a particular price, known asthe strike price. When you buy a put, you pay a premium for the right,but not the obligation, to sell the stock at the strike price.
TIME DECAY FIGURE 1
In Figure 1, we show an example of some call and put option premiums on Reuters. Inour example, the stock price is $45 per share and the three strikeprices are $40, $45 and $50.
Looking at the calls, notice that the $40strike call has a total premium of $5.75. It has $5.00 worth oftangible or exercise value. (That is if you exercise it, you can buythe stock at $40 and immediately sell it at $45). This call is said tobe in-the-money. This option also has $0.75 worth of time premium.(This is the part of the option premium that is not tangible value.)
The$45 strike call has a total premium of $2.25. It is said to beat-the-money. It is has no tangible value, but with the stock equal tothe strike price, it has a time premium of $2.25. In fact, this is thehighest time premium of all the strikes. The $50 strike call has notangible value. It is said to be out-of-the-money, since you would notwant to exercise it. It has a lower time premium of $0.65.
Lookingat the puts, we see similar patterns. The in-the-money $50 strike puthas a total premium of $5.65, of which $5.00 is tangible value (sinceyou can buy the stock at $45 and exercise your right to sell it at $50)and $0.65 is time value. The at-the-money $45 strike put has thehighest time premium of $2.25, while the out-of-the-money $40 strikeput has no tangible value, and a time premium of $0.75.
...To Be Continued In "Part Two: Options As Insurance"
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About Lawrence D. Cavanagh
Lawrence D. Cavanagh is Editor (and Senior Analyst) of The Value Line Daily Options Survey. The Value Line Daily Options Survey offers evaluations and rankings on virtually the entire universe of regularly listed equity and ETF options, using the Value Line common stock ranks and proprietary volatility forecasting methodology. Before joining Value Line in 1991, Mr. Cavanagh was an options strategist for Capital Market Technologies (subsidiary of Elders Finance), helping design long-term synthetic foreign currency and gold option hedges. Before that, he was Director of Foreign Currency Options for the Chicago Board Options Exchange. Other work experience includes Dean Witter Reynolds (VP, Senior Currency Analyst), European American Bank (Director of Currency Forecasting) and the Federal Reserve Bank of New York (Assistant Economist).
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