One of the major differences when learning to trade options as opposed to equity trading is the impact of time on the various trade instruments. Remember that option premiums reflect the total of both intrinsic (if any) and extrinsic (time) value. Equities are not affected by the passing of time unlike many movie stars. Even though Raquel Welch is still considered to be still quite attractive by many, her look is not the same as it was decades ago when she was known as a “bombshell”. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.
While this decay of time premium to a value of zero is reliable and undeniable in the world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.
Some of the most dramatic changes in behavior can be seen in the trading strategy known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.
To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the same strike price constructed together in the same underlying in the same expiration. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.
The butterfly has the interesting characteristic in that it responds sluggishly to price movement early in its life. For example in the first two weeks of a four week option cycle, time decay or theta is slow to erode. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the spread becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week. Beauty is in the eye of the beholder!
Senior Options Instructor