We could be up one day and lose all our profits and then some the very next day. The market may be positioned to move a certain way, but there’s no guarantee it will actually follow through.
But there IS one thing that IS guaranteed –and that’s time decay — or the notion that time will continue moving. That is the ONLY thing that is guaranteed.
Wait a minute – I can make money by betting that time will continue moving?
Yes, that’s right. It’s not exactly as easy as that, but yes, that’s the general idea. You see, with options, since there is a time element to the option’s value– called theta — or time decay — this is the ONLY element or portion of options trading that is guaranteed. As long as you bet that time will go by (and nothing else moves, like the underlying stock) –which you do when you sell options — you can make money.
Of course, it’s not easy to completely isolate out the time component of options — otherwise everyone would easily make money with options. When you bet on time decay (betting the option will go down to 0 in intrinsic value via selling the option to someone else), you will automatically incur some directional risk –particularly as the date of options expiration gets closer and closer. If the option/underlying stock drifts downward, you’re in OK shape. If it drifts upward, you’re in trouble. During the two weeks prior to an options expiration — and particularly in the last few days — time decay happens the fastest. That’s when it’s easiest to magnify gains with time decay, but it’s also the easiest to magnify losses if the market moves against you.
There are some ways to mitigate this directional risk — through fancy things such as credit spreads and iron condors, but you can never completely eliminate directional risk. How MUCH you can make depends on how many days remain until an option expires—assuming you are selling that option, rather than buying. By selling an option, you can capitalize on time decay (gains are magnified when the underlying doesn’t move up). By buying an option, time decay works against you (your losses magnify by the day if the underlying doesn’t start moving up).
You see, each option has an expiration date—pretty much every Friday there is a different set of options that expire. As long as the option you are selling is not “In-the-money” — meaning the stock is not above its strike price (for a call) or for a put — not BELOW its strike price—or in other words, the option has no “intrinsic value” — then the value of that entire option will drift towards 0 at 4pm / 4:15pm on Friday options expiration. If you’re selling that option, drifting towards 0 is exactly what you want. That’s time decay — and when it expires worthless, you get to collect/realize the full value of that option automatically.
That’s how time decay works — and that’s the only thing that’s guaranteed in options trading. As long as you sell options that expire out-of-the-money and have no intrinsic value on those Fridays, then you make money by selling theta and capitalizing on the simple concept that the time remaining in an options contract will always dwindle down towards zero at expiration.
However, if you are wrong and the options become in-the-money prior to or by expiration (underlying stock moved upward rather than unchanged) — you could lose multiples of what you would have won if you were correct. So it’s almost like collecting $1 each time you are correct. But if you lose, your loss wouldn’t just be $1 — it could be $5.
Hey, nobody said trading — even on something like time decay — is necessarily easy. But if you can make good educated guesses here and there, you can bump up your odds of winning significantly and make some small but consistent money by capitalizing on time decay.
So that’s how you make money with time decay – by selling options and hoping they expire out-of-the-money at expiration so that you can fully realize the saleprice at which you sold that option and the buyer that option is holding onto something he can’t exercise against you.
Leverage is just one of the many benefits that options have to offer. To learn more about these check out the other videos in the How To Make Money With Options video series with .com. Make sure you subscribe to our youtube channel and visit our website for daily stock market updates on the S&P500 – and learn how to make $1,000 every week using options and futures.