There are a lot of "rules" that option traders will use to determine what they are buying or selling and when. For example, it is not uncommon for option traders to sell a call when they are bearish and there are only a few weeks before expiration rather than buying a put. These are both short term bearish positions so why is there a bias towards the short position rather than the long put?
The easy answer to the question above is that because options will lose time value at an accelerating rate the closer they get to expiration it makes sense to sell or short them rather than buy them to capitalize on that quick loss of value. Time value is that portion of an option's price above its intrinsic value. In the video I will go into more detail about what that means and how to determine what time value is for any given option. Time value falls until it equals zero at expiration and the decline can hurt your profitability if you are long when the decline starts to accelerate. Therefore short term put buyers are at a disadvantage to call sellers as their puts start "bleeding theta" or time value.
How sensitive an option is to the passage of time is called "theta," which for option traders is a synonym for time value itself. Theta will tell you how much time value or theta is going to melt each day you hold the option and unlike delta doesn't change very much on any given day with different strike prices. In this series we will be looking at theta and will discuss why its an important subject for option traders to understand as you select the right option strategy for the right situation.
- To see the previous series about option delta click here.
