Correct handling of Time Value decay in Option can lead to higher returns

Shubham Agarwal

As we have discussed a few times before as well, Time Value element in Options is a tricky part to handle because unlike Price of the underlying, Time Value is a certain phenomenon like Death and Taxes.

While the certainty closes the door for any positive surprise in the market, it most certainly gives us an opportunity to create a defense mechanism to deal with its ill effects due to the varying predictability of the Time Value decay.

Let us today discuss a few of those adjustments that we can keep in mind to optimize this wasting element in option premium.

Shubham Agarwal

CEO and Head of Research|Quantsapp Private Limited

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Two characteristics of Time Value decay has to be kept in mind during this discussion

#1 Time Value Decay is a constant phenomenon, a bit of Option premium would be reduced every day for sure

#2 There is a pattern in which Premium erodes due to the passage of time. The speed of this erosion is slow at the beginning of the expiry and erosion is faster towards the end of the expiry

In other words, Speed of Decay in Option Premiums due to the passage of Time is indirectly correlated with Time left for Expiry.

This brings us to the simplest and the first Re-Shaping of Option Trade according to time left for expiry. The easiest and the most basic Option trade is to Buy or go Long on a single Option, Buy a Call or a Put.

While the gain or loss in this option is mainly predicated to the movement in the price of the underlying, we still have to account for time value. Hence, conventional wisdom says along with a price stop loss on the underlying do have a time stop loss for a Long Option trade as well.

Now keeping the Characteristic #2 in mind the addition to the conventional wisdom that we are trying to impose is the magnitude of the time stop loss.

Simple to understand, logical and has kind of worked for me in the past is this time stop loss gauge. Hold a Long Option with Time Stop-Loss (No. of Days) = No. of Weeks Left for Expiry.

So essentially, we would hold Long Option at the beginning of the expiry for 4 days post which if trigger Time Stop-Loss. Similarly, in the week of expiry since the number of weeks left for expiry are zero, we would get rid of the options during the day itself.

Going one step further in Vertical Spreads where we have one Long Option along with one short Option of the same type, expiry but in relatively higher Call/ Lower Put, the reshaping comes in terms of choice of these strikes.

In the beginning of the expiry it is prudent to keep larger gaps (2-3 strikes) between Long and Short Options due to very heaviness in the time value element. This gap can narrow down to just 1 strike towards the end of the expiry.

Last but not least, considering the speed of time value decay when ratios are to be resorted. Avoid selling multiple options in the beginning of the expiry against one Option bought (Ratio Spread). Similarly, avoid Buying multiple Options against one Option short (Ratio Back spread) towards the end of the expiry.

In fact, keep it opposite, resort to Back Ratios in the first week of the expiry and resort to Ratio spreads towards the end of the expiry. Correct handling of Time Value decay in Option can actually accentuate Return from the same view.

(The author is CEO & Head of Research at Quantsapp Private Limited.)