Time decay, also known as theta, is defined as the rate by
which an option’s value erodes into expiration. The
value of the option over parity to the stock is called
extrinsic value.
Since an option is a depreciating asset, meaning it has a
limited life, the extrinsic value in the option will wither
away daily until expiration. This “decay” is
not a linear function meaning it is not equally distributed
between all of the days to expiration.
As the option gets closer to expiration, the daily rate of
decay increases and continues to increase daily until
expiration of the option. At expiration, all options in the
expiration month, calls and puts, in-the-money and
out-of-the-money must be completely devoid of extrinsic
value as noted in the time value decay charts below.
As more time goes by, the options extrinsic value
decreases. Again, it is important to note that the rate of
this decrease is not linear, meaning not smooth and even
throughout the life of the option contract. An option
contract starts feeling the decay curve increasing when the
option has about 45 days to expiration. It increases
rapidly again at about 30 days out and really starts losing
its value in the last two weeks before expiration.
This is like a boulder rolling down a hill. The further it
goes down the hill, the more steam it picks up until the
hill ends.
By selling the option and owning the stock, the covered
call seller captures the extrinsic value in the option by
holding the short call until expiration.
As mentioned earlier, an option’s loss of extrinsic
value over its life is called time decay. In the covered
call strategy the option’s time decay works to the
seller’s advantage in that the more that time goes
by, the more the extrinsic value decreases.
Key Point – The covered call strategy provides the
investor with another opportunity to gain income from a
long stock position. The strategy not only produces gains
when the stock trades up, but also provides above average
gains in a stagnant period, while offsetting losses when
the stock declines in price.
We have now seen how a covered call strategy is constructed
and how it is supposed to work. Keep in mind that the trade
can be entered into in two ways. You can either sell calls
against stock you already own (Covered Call) or you can buy
stock and sell calls against them at the same time (Buy
Write).
Example 1
You own 1000 shares of Oracle at $9.50.
The stock has been stuck around this level for a long time
now and you have grown impatient. You finally give in and
sell the front month (November for example) at-the-money
calls. The at-the-money calls would have a strike price of
$10 if the stock was trading at $9.50.
You sell the calls at a $.50 premium per contract which
creates a $10.50 breakeven point. Remember, in a buy-write,
the breakeven point is the strike price plus the option
premium. Let’s look at what our returns will be in
each of the three scenarios.
----------------------------------------------------
Brett Fogle is the president of Options University. Brett
and his veteran traders teach safe and effective options
trading strategies. Free strategies can be found at
http://www.optionsuniversity.com/blog
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