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The Time Decay Factor in Options Trading

If you want to make money trading but you don’t have a large capital outlay, then you should definitely think about options trading. This form of trading has all the advantages of stock trading without the need for a person to set aside a significant amount of money for investing.

Furthermore, there is also the fact that it tends to be less risky when compared to investment opportunities, such as equities, and that it carries an inherent upside of offering higher-than-normal returns on modest investments. These are just but some of the many reasons why this form of trading is increasingly becoming popular among people who are just starting out as far as online trading is concerned.

However, diving into trading without acquiring enough knowledge about the various things that can affect your position is risky. Before you start options trading, it is important to understand the basics of what can increase your chances of making a profit on your trades. Learning about the underlying principles of trading will also make your life as a trader less stressful as you will be able to anticipate changes and the effects that they will have on your positions.

One of the most important concepts that every options trader should understand is the effect that time has on their ability to make a profit. This concept is usually referred to as time decay.

Here is what you should know about time decay and the effect that it has on your investments.

Time works against an options’ buyer

Option contracts tend to have an expiration date. This is a date beyond which an option contract is considered to have expired. Once time lapses, the option essentially becomes worthless. As a result, the value of your options will be declining towards zero as the set date approaches.

If you are a buyer of an options contract, the more time that you take to exercise your options, the less the opportunity for you to benefit from it. Keeping this in mind will help you to know the right time to buy options and the right time to sell them. It can also present you with the opportunity to take advantage of these changes in values in such a way that you can make a profit in the process.

The decline is steeper as the expiration date approaches

It isn’t just that the value of the options contract declines as time lapses. The rate of decline always increases depending on how close the date of expiration is. Essentially, changes in price are smaller at the beginning. As time goes by, these changes become larger and larger. This increased rate of decline provides an increased opportunity to make losses. However, for those who understand how to take advantage of it, it provides an opportunity to benefit.

Time decay isn’t always the enemy

As with any other marketplace, something that is bad for one party can be beneficial to another. As an options trader your goal is to look for opportunities and take advantage of them.

Buying an asset that is increasingly decreasing in value is definitely not prudent. However, selling this same asset can prove beneficial. When you keep this in mind, you will definitely be able to twist the principle of time decay in your favor. As a general principle, when you are selling options, time decay works in your favor.

The winning strategy

The first step towards taking advantage of the time decay factor is to be aware that it exists. The next step is to expect some of your positions to eventually lose value with the passing of time. Since you will be expecting this to happen, you’ll be able to plan for it and react accordingly. Understanding the time decay concept will therefore ensure that you are not caught off-guard and that you have a way out in case things don’t go your way.

Spreading your risk accordingly and choosing the right time to buy and sell your options is the best way to guarantee success as far as options trading is concerned. Doing it right will ensure that you get all the benefits that come with options trading. This includes the benefit of hedging the downside risk of your overall investment portfolio.

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