Options – Negative Time Erosion vs. Positive Time Erosion

January 7, 2010

Put and Call Options – why do they often expire worthless?

There have been studies that indicate put and call options often expire either worthless or extremely devalued. There are reasons why options, when purchased alone (not as part of a spread) often expire worthless. Most investors, unfortunately, do not approach trading or investing as if they were running a business. Many investors “gamble” using get-rich-quick strategies. There are countless options available for investors to purchase and many of them “tease” the investor into thinking, incorrectly, that there is a way to quickly generate a profit. Although earning profits can be made purchasing options, doing so is an exception rather than the norm.

Individual options have negative Theta (each day, provided that the underlying asset does not move much or become relatively high in volatility, the option loses time value). This creates a situation where the investor is challenged with both a race against the calendar and an extremely well-timed prediction of market direction.

Not only is the investor required to pick the correct market direction, the timing of the decision must be precise. This can be a daunting task. That being said, often times, the investor is correct in their prediction of market direction; however, the investor loses money. More often than not, the investment loses money because the initial investment has a high negative time erosion factor (negative Theta).

We try to construct trading strategies the have positive time erosion (or sometimes slightly neutral time erosion).  Not every strategy contains the inherent properties required to set up a positive time erosion trade.  Note that it is quite possible to have a positive time erosion (positive theta), but this typical requires a combination of buying and selling options as a spread. 

In certain cases, for example, if an investor is extremely bullish – in such a case, then one could justify purchasing an at-the-money option with plenty of time until expiration.  But generally speaking, we try to select option strategies that have positve time erosion.

{ 1 comment… read it below or add one }

admin February 9, 2010 at 12:58 pm

Note that when a market makes an extreme move, such as the recent move in the Japanese Yen Futures market, volatility will most likely increase. In some cases, we can be long puts or calls, provided that we feel volatility will remain elevated.

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