Learn With ETMarkets: All you need to know about premium decay in options trading

We also discussed the components of Premium in options and how they are calculated with real examples.

Let’s take a moment to understand how any other insurance works

Consider you Own a car of INR 20LAC, the insurance premium paid for the first year will be, say 60k, but from the second year onwards every single year this premium would drop, it will be 55k in 2nd year, 50k in 3rd year and finally when the car becomes very old, there won’t be any insurance for it.

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Similarly, Options also have expiry (Monthly and weekly), and the Extrinsic value of Options becomes Zero. Just like in the case of cars, the premium keeps dropping exponentially every day.Here is what the Extrinsic value decay graph looks like:

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X-AXIS Represents Time and Y-AXIS represents the Extrinsic value of Premium.

On the first day of the contract, the Extrinsic value is highest and on the last day of the contract (Expiry), the extrinsic value becomes Zero.

Notice how the curve is exponential, it indicates the decay is slow in the first half and aggressive in the second half of expiry.

Example: If there are 30 days left for expiry, the decay will be little in the first 15 days and very aggressive in the last 15 days.

Hence you might have observed, it is usually not advisable to buy options when we are extremely close to expiry, as the decay is constantly eating up our gains.

You might have also observed the script going in your favour, but options are going against you, the main reason for it is this decay.

Thus, on the day of Expiry ATM and OTM becomes Zero, as they are made only of Extrinsic value and ITM value is just Intrinsic value (difference between CMP AND Strike price).

Apart from Time, the other factors that effect Option premium pricing are volatility, Change in Risk-free rate of return, and unexpected volumes.

In the next lesson, we will discuss the risk and rewards associated with trades as option Buyers.

(The author is Co-founder Algofox.com)

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)