The Option Buyer's Enemy

By Jon Najarian

It's important to understand how the passing of time affects options. Bottom line: all options are affected by the clock, no matter what stocks, indices or exchange-traded funds (ETFs) the options are based on.

An option will also decay (i.e., its price will change in relation to the amount of time left until the option's expiration date) slower or faster depending on how much time is left in its "life."

For example, let's talk about an option with nine months remaining until it expires. During the first three months (or, up to six months until expiration), the "time portion" of the option will depreciate at a very slow rate.

However, during the last three months (heading into the expiration date), the decay -- or depreciation of time -- starts to speed up. In the final month, time decay wreaks the most havoc because that expiration date is right around the corner, and it's "do or die" time for that option to perform!

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The reason for the quick decay is simple: There's only a set amount of time in which an option trade can become profitable. If the option is out-of-the-money, the time left for it to become profitable is limited and, thus, the chances of it becoming in-the-money are less likely.

(A call is out-of-the-money when its strike price is greater than the market value of the underlying stocks, and a put is out-of-the-money when the strike price is less than the current value of the underlying security.)

Projecting a time frame in which to purchase an option is very important.

If you believe that the option will work for you in the short term, then you can generally buy an option 30 to 90 days away from expiration.

If you believe that the option will become profitable in the medium term, you'd want to consider options that are three to nine months away from expiration.

Although options are designed to be short-term trades in nature, you can initiate a longer-term play (i.e., projecting out about nine-plus months, sometimes up to two or three years depending on the option chain available for a particular stock) through long-term equity anticipation securities, or LEAPS.

Always remember, no matter what type of option term you buy, options are a "wasting asset," meaning time works against you from day one, so be sure to keep a close eye on any investments you make.

For a trade that isn't going in your favor as expiration nears, it's possible to try to turn the odds in your favor. You can choose to exit the trade in a timely manner or to "roll" your option up, down, forward or back -- meaning, you can replace your existing position with a new options play on the same security by choosing an earlier or later expiration date and/or a higher or lower strike price. In this way, you have a real shot at transforming the "enemy" of time into an ally.

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Jon Najarian is the editor of ChangeWave Options Trader. Step into trading with Jon and learn how to make great trades with his step-by-step directions. Click here to start trading with Jon today.

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