by Tom Doan
In the Snider Investment Method, we sell options for a premium, which is the amount we receive for selling someone the right to purchase our shares at a particular price over a given period of time. This will be the first of a series, with each article explaining a different component that helps determine the premium of a stock option. Today I will focus on one of the most important factors: time value.
Each option contract is associated with a specific expiration date. For example, an XYZ Nov11 55 Call expires on the Saturday following the third Friday of November 2011, which is November 19, 2011. The further away the expiration date is from today, the more valuable the option is, which results in a higher premium. An option with a longer time horizon until expiration is more valuable, because the stock has more time to move past a certain price. For example, a $30 stock today has a greater chance to increase to $35 in one month than in a week.
With all other factors remaining the same, the difference in premium between a November and December call with the same strike price is the time value. An investor is willing to pay more for the December call because it gives them a longer time horizon. As the date reaches closer to expiration, the time value will slowly decay. However, time value is not proportionate; meaning the time value for a call option with 60 days to expiration may not necessarily be twice the value of a call option with 30 days to expiration. In fact, the time decay is greatest in the last 30 days of an option, meaning that the time value decreases at the greatest rate as expiration draws nearer.
With the Snider Investment Method, on Trade Day you would typically sell options with around 25-35 days until expiration, which allows us to take advantage of the threshold where the time value begins to decay at the fastest rate. This is why we consistently sell the following month’s options in the Snider Method instead of options with two or three months to expiration. Along with time, there are many other factors that influence option premiums which will be covered in the future. Although you cannot control time, you can take advantage of the opportunities it presents.