A challenging aspect of shorter-term options is the erosion of the time premium portion of the option’s price. Time premium is the amount of the option’s price that exceeds its intrinsic value. As an option nears expiration and time decreases, the marketplace is increasingly less willing to pay any premium over intrinsic value until an option is trading purely for intrinsic value at expiration.
Time premium erosion works in favor of short-term option sellers. Conversely, the option buyer must overcome the erosion of time premium to profit from a long option position. The graph below is a representation of theoretical time erosion for longer-dated options:
As you can see from the graph, time erosion of options premium is not linear (i.e., it does not occur in a straight line). The mathematical reasons for this are complex. The result is that the erosion of time premium in the earlier months of an option’s life is much less dramatic than the erosion that occurs in the last few months. Because of the long timeframe of LEAPS® options, this effect is even more pronounced. The time erosion that occurs in the first several months of a LEAPS® option is minimal.
However, when LEAPS® options become shorter-term options (time to expiration is less than one year), they behave like all other shorter-term options, as the graph shows. Time erosion becomes more pronounced and has a greater impact, especially in the last 90 days of the option’s life.
Slow time erosion may frustrate LEAPS® sellers. However, the higher premiums available to writers provide a good rate of return in covered writing and other strategies because of the increased time premium in LEAPS® options.
Content Licensed from the Options Industry Council. All Rights Reserved. OIC or its affiliates shall not be responsible for content contained on Company’s Website, or other Company Materials not provided by OIC
Content licensed from the Options Industry Council is intended to educate investors about U.S. exchange-listed options issued by The Options Clearing Corporation, and shall not be construed as furnishing investment advice or being a recommendation, solicitation or offer to buy or sell ant option or any other security. Options involve risk and are not suitable for all investors