As traders in Hong Kong woke up to another day of market volatility, they were met with a sobering realisation: many of their options had lost value overnight. This is due to the phenomenon of “decay”, whereby the time value of an option erodes as it gets closer to expiration.
For traders who rely on options for hedging or speculation, this can be cause for concern – especially when markets are in turmoil.
However, some strategies can help mitigate the effects of decay, so it’s essential to understand them before trading in Hong Kong’s complex market environment.
What is options decay?
Options are derivatives, meaning their value is derived from the underlying asset. With an option, the holder can buy or sell an asset for a set price at some point in the future. Because options provide the holder with the potential to make a profit, they are a popular investment tool. However, options also come with a unique set of risks. One of these risks is known as “options decay.”
Options decay occurs because options have a limited lifespan. Every day that passes, the option becomes less valuable. This is due to the time value component of an option’s premium. The time value is the amount of the premium that is attributable to the option’s remaining lifespan. As options approach expiration, their time value diminishes. This eventually leads to options decay.
While options decay can be a risk for investors, there are ways to mitigate this risk. One method is to buy options with a longer lifespan. Another strategy is to engage in “rolling.” This involves closing your current position and opening up a new one with a later expiration date. Investors can help offset the effects of options decay by taking these measures.
Risks of option decay
Share examples of how traders can use overnight decay to their advantage
While most investors focus on the potential upside of their trades, savvy traders know there is also value in taking advantage of overnight decay.
Also known as the time value of options, overnight decay refers to the gradual erosion of an options contract’s value as it approaches expiration. Because all other things are equal, the longer an options contract has until expiration, the more valuable it is. While this may seem a disadvantage for traders, savvy investors can use overnight decay to their advantage.
By selling options with high levels of time value, traders can generate income while minimising risk. And by carefully monitoring their positions, they can keep a close eye on when time value erodes and adjust their strategy accordingly.
By learning more and taking advantage of overnight decay, traders can give themselves a leg up on the competition.
Resources on options decay
Several resources are available for those who want to learn more about time decay and how it affects options. Investopedia has a good article that explains the basics of time decay and how it works. The Options Clearing Corporation (OCC) also has a helpful educational page on its website that details time decay and its effects on options contracts.
Finally, for those who want to dive deeper into the topic, numerous academic articles are available on the subject. With some research, you can find everything you need to know about how time decay affects option contracts, as well as the strategies required to trade options efficiently.
The bottom line
The evidence suggests that the decay may be more gradual, at least for some options. More research is necessary to determine whether this pattern is consistent across all options and under all market conditions. Nevertheless, the current findings suggest that investors should exercise caution and have sound investment strategies in place when trading in Hong Kong’s options market.
