Let's Talk About: Time Decay
TIME DECAY BASICS
Whenyou buy a call, you pay a premium for the right, but not theobligation, to buy a particular stock at a particular price, known asthe strike price. When you buy a put, you pay a premium for the right,but not the obligation, to sell the stock at the strike price.
TIME DECAY FIGURE 1
In Figure 1, we show an example of some call and put option premiums on Reuters. Inour example, the stock price is $45 per share and the three strikeprices are $40, $45 and $50.
Looking at the calls, notice that the $40strike call has a total premium of $5.75. It has $5.00 worth oftangible or exercise value. (That is if you exercise it, you can buythe stock at $40 and immediately sell it at $45). This call is said tobe in-the-money. This option also has $0.75 worth of time premium.(This is the part of the option premium that is not tangible value.)
The$45 strike call has a total premium of $2.25. It is said to beat-the-money. It is has no tangible value, but with the stock equal tothe strike price, it has a time premium of $2.25. In fact, this is thehighest time premium of all the strikes. The $50 strike call has notangible value. It is said to be out-of-the-money, since you would notwant to exercise it. It has a lower time premium of $0.65.
Lookingat the puts, we see similar patterns. The in-the-money $50 strike puthas a total premium of $5.65, of which $5.00 is tangible value (sinceyou can buy the stock at $45 and exercise your right to sell it at $50)and $0.65 is time value. The at-the-money $45 strike put has thehighest time premium of $2.25, while the out-of-the-money $40 strikeput has no tangible value, and a time premium of $0.75.
...To Be Continued In "Part Two: Options As Insurance"
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