With Options, Time Matters

by Keith Schap   ISSUE 210 | NOV 2003

Much of what you pay for when you buy an option is time. The logic is simple. The more time to expiration, the more opportunity you have for something good to happen. Therefore, all else the same, an option with more time left will cost more than one with less time left.

A sports analogy might help. Contrast a football team that’s down a touchdown with one minute left in the first quarter with one that’s down a touchdown with one minute left in the fourth quarter. The first team still has many opportunities to turn the tide. The second team is all but out of opportunity. Time matters.

A Futures-Options Contrast

The time factor differentiates options from futures. If you buy a CBOT® mini-sized Dow contract, and the DJIA moves higher, you likely will show a gain as well. If the DJIA does little or nothing, you’ll probably be close to break even (ignoring transaction costs). Further, if the Dow rallies 200 points on the first day of the trade, the gain is the same as when the Dow rallies 200 points by the 14th day of the trade, or at any other time. With futures, time isn’t a factor.

Option traders cannot be indifferent to time. Suppose that December CBOT DJIA futures are trading at 9290 and there are 84 days until option expiration. Your quote screen might include the data shown in the first two columns of Exhibit 1.

Exhibit 1: Time and December Options on CBOT DJIA Futures
	Initial Price	Ending Price	Price Change
December CBOT DJIA Futures	9290	9290
Days to Expiration	84	70
December Call Strike Price
9300	34.30	31.30	-3.00
9400	29.25	26.30	-2.95
9500	25.00	22.10	-2.90
9600	20.00	17.30	-2.70

After the passage of 14 days, assume that the Dow remains at 9290, or is back to that level. If all the other pricing factors, except days to expiration, also remain unchanged, you will see the call prices with 70 days to expiration in the third column. And, as column four shows, the December 9300 call will have lost 3.00 option points, or $300, the 9400 call will have lost 2.95, or $295, and so on. Even though the futures price is the same on both the initial day and the ending day, the options have all lost value.

Options are subject to time decay. This is a negative factor for option buyers but a positive factor for option sellers.

Exhibit 2 shows a similar situation involving October calls on December CBOT DJIA futures. On the same day that the December options had 84 days remaining until expiration (Exhibit 1), the October options had 21 days remaining.

Exhibit 2: Time and October Options on December CBOT DJIA Futures
	Initial Price	Ending Price	Price Change
December CBOT DJIA Futures	9290	9290
Days to Expiration	21	7
October Call Strike Price
9300	17.00	9.60	-7.40
9400	11.50	5.00	-6.50
9500	7.00	2.00	-5.00
9600	4.95	0.95	-4.00

Again assuming the passage of 14 days and no other pricing factor changes, you can make five observations:

• The initial prices of the October calls are much less than the initial prices of the December calls on the same date.
• All four calls suffered losses even though the futures price remained unchanged.
• The October calls lost more, in both nominal and percentage terms, than the December calls over the same 14-day period.
• The rate of time decay accelerates as expiration approaches, especially during the last month before expiration.
• The nearby at-the-money 9300 call lost more to time than the farther out-of-the-money calls.

Consider the December 9500 call and the 9500 October call in the previous examples. In order for either of these calls to have any value at expiration, the underlying futures contract must rally at least 211 points, to 9501.

Time and Trading

Exhibit 3 offers another way to look at the effect of time on an option trade. It contrasts a December 9900 call with a November 9900 call and looks at what will happen to each if the futures price rallies slightly from 9710 to 9800 after one day or after 14 days. The assumption is that all other pricing factors remain the same.

Exhibit 3: The Effect of Time on Two Option Positions
December futures	9710		9800		9800
Days to December Expiration	60		59		46
December Call	Call Price	Delta	Price	Change	Price	Change
9900	15.90	0.39	19.45	3.55	16.70	0.80
Days to November Expiration	32		31		18
November Call	Call Price	Delta	Price	Change	Price	Change
9900	8.90	0.33	12.00	3.10	8.20	-0.70

One way to express a bullish opinion is to buy a call. Conversely, one way to express a bearish opinion is to sell a call. Remember, when you buy options, time decay is an enemy. When you sell options, time decay is a friend.

Given the examples of Exhibit 3, a useful rule of thumb might be that you should consider buying options with more time to expiration to reduce the ravages of time decay. Notice that after one day, both options show gains. However, after 14 days, the December 9900 call shows only an 0.80 gain-2.75 option points less than the one-day gain, yet the futures move was the same. Even more interesting-the November 9900 call generates a 0.70 loss-3.80 option points less than the one-day gain, yet again the futures move was the same.

The mirror image rule of thumb is that you should consider selling options with less time to expiration to maximize the effect of time decay, preferably a month or less. To illustrate, suppose that you are selling either of the two calls in Exhibit 3, given the same assumptions. Sellers of calls, being bearish, anticipate a falling market, so in this case, the 90-point rally is an adverse move. If you sell the December 9900 call for 15.90 and buy it back after 14 days for 16.70, you will lose 0.80 option points, or $80. However, if you sell the November 9900 call for 8.90 and buy it back after 14 days for 8.20, you will gain 0.70 option points, or $70.

As a seller of the November 9900 call, you can make a little money even when the market moves slightly against this position, thanks to the effect of time decay. It is important to remember, when contemplating the selling of options, that option sellers can suffer unlimited losses when the market moves against them. In contrast, the loss to option buyers is always limited to the option price paid, exclusive of transaction costs.

Even more important, when you buy options you must consider the effect of time because time decay can reduce the potential gain. It can even overcome favorable futures market moves unless they are quite large.

It bears repeating: when you trade options, time matters.

Keith Schap is a Senior Writer in Business Development at the Chicago Board of Trade.

Laura Oatney is editor of LindForum. She can be reached at editor@Lind-Waldock.com.

Futures trading and options on futures trading involve a substantial risk of loss, including more than the original investment, and thus may not be suitable for all investors.

The information in this publication is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, nor any trading result, and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations.

"Dow Jones," "The Dow®,""Dow Jones Industrial Average," "DJIA" are service marks of Dow Jones & Company, Inc. and have been licensed for use for certain purposes by the Board of Trade of the City of Chicago, Inc. (CBOT®). The CBOT futures and futures options contracts based on the Dow Jones Averages are not sponsored, endorsed, sold, or promoted by Dow Jones, and Dow Jones makes no representation regarding the advisability of trading in such contracts.

© 2003 Lind-Waldock, A Division of Man Financial Inc. All Rights Reserved. Futures Trading Involves Risk of Loss.