Time Erosion vs. Delta Effect
One of the most challenging aspects of shorter-term options is the erosion of the "time premium" portion of the option's price. Time premium refers to the amount of the option's price that exceeds its intrinsic value. As an option nears its expiration date and the time period shortens, the marketplace is less and less willing to pay any premium over intrinsic value until, at expiration, an option is trading purely for intrinsic value.
As a seller of shorter-term options, time premium erosion works in your favor. Conversely, the option buyer has to overcome the erosion of time premium to make a profit from a long option position. The graph below is a representation of theoretical time erosion for longer-dated options:
Note: The prices presented in this graph are for illustrative and educational purposes only. They do not represent any actual options prices and are not intended to. Options prices on actual stocks may differ significantly from those shown.
As you can see from the graph, time erosion of options premium is not linear (i.e. it does not occur in a straight line). The mathematical reasons for this are complex, but the result is that the erosion of time premium in the earlier months of an option's life is much less dramatic than the erosion that occurs in the last few months. Because of the long time frame of LEAPS® options, this effect is even more pronounced. The time erosion that occurs in the first several months of a LEAPS® option is minimal.
However, when LEAPS® options become shorter-term options (time to expiration is less than one year), they behave like all other shorter-term options, as the graph shows. Time erosion becomes more pronounced and has a greater impact, especially in the last 90 days of the option's life.
What does this mean to options investors? Buyers of LEAPS® options have less time premium erosion to fight than buyers of shorter-dated options. The tradeoff, however, is that LEAPS® options offer less "leverage." The deltas of LEAPS® options will not increase dramatically as with shorter-dated options since there is so much time remaining until expiration. Any increase in option value due to an increase in the price of the underlying stock will be tempered by this lower gamma effect.
The slow time erosion will frustrate LEAPS® sellers. However, the premiums available to writers, because of the increased time in LEAPS® options, can provide a good rate of return in covered writing and other strategies.
© 2019 The Options Industry Council. All Rights Reserved. Visit us online at www.optionseducation.org