One of the things that differentiates option trading from stock trading is that options have a finite life. Every option has a fixed expiration date, after which it will cease to exist. That means that the owner of an option has only a limited time in which to be proven correct by the market.
The other side of that coin is that the person who sold the option has only a limited time to wait for the outcome of his trade as well. As I have written before, an option is a zero-sum proposition. If the option buyer makes money it comes from the option seller, and vice versa. The sum of the gains by one side and the losses of the other side is zero. This is true of any derivative (options, futures contracts, forex contracts, or swaps).
From the point of view of the option seller, the expiration can’t come soon enough. The seller received money originally in exchange for the option. He or she now would like to see the value of that option diminish to nothing. If it does, all the money received for the option is pure profit.
The option buyer believed that he knew which way the price of the stock was going to go. He bought call options if he expected the stock price to go up; or puts if he expected the stock price to go down. Let’s look at a put example. Say a $100 stock is expected to go down. If a trader bought a put at the $100 strike price, that option gives him the right to sell the stock for $100 no matter its actual market value. No matter how the price of the stock dropped, even to zero, the put buyer would have the right to sell it at $100. The seller of the put option would be legally obligated to buy that stock and pay the $100.
This right to sell the stock at a fixed price has more value if that price is above market value. The lower the market price of the stock is, the greater the value of the put. This is because the owner of the put could buy the stock at the low market value, and then through exercise of the put, sell it at the $100 strike price. If the stock were at $90, then the $100 put would be worth at least $100 – 90 = $10. With the stock at $80, the put would be worth at least $20, and so on.
Note that I said the put would be worth at least the excess of its strike price ($100) above the value of the stock. That difference is referred to as intrinsic value. The put would in fact be worth more than that as long as there was still the possibility of the stock dropping even further before expiration. This additional value, beyond the intrinsic value, is referred to as extrinsic value or time value.
When there is no longer any time left in the option’s life it will have no time value. Its only value then will be its intrinsic value. If at that time the stock is at or above $100, there will be no intrinsic value and the put will be worth nothing. But prior to expiration the put will have some time value.
As each day passes the amount that the stock could move in the remaining time diminishes and so does the time value in the option. The rate at which the time value declines accelerates as expiration approaches. This is bad news for the option owner. To make a profit the stock must go down, pouring intrinsic value into the put enough to more than replace the time value that is being lost.
From the point of view of the put seller, all the stock has to do is remain above $100. As long as it does the put has no intrinsic value; and when all its time is gone it will be completely worthless.
One of the ways to profit on options is to sell options that have time value in them and watch as that time value melts away. Profits are not guaranteed; if the stock goes the wrong way the time value that we sold might be replaced by intrinsic value and we could lose. But the options seller does have the “wind at his back” because time is his friend rather than his enemy.
Profitable option trading often takes advantage of time decay. If this is of interest to you, look into our Professional Options course.