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:
Note: The prices presented in this graph are for illustrative and educational purposes only. They do not represent any actual options prices and are not intended to. Options prices on actual stocks may differ significantly from those shown.
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.
What does this mean to options investors?
- Buyers of LEAPS® options have less time premium erosion to fight than buyers of shorter-dated options.
- LEAPS® options offer less leverage.
- The Deltas of LEAPS® options will not increase as dramatically as with shorter-dated options since there is so much time remaining until expiration.
- A lower Gamma tempers any drastic changes to an option’s Delta due to the amount of time until expiration
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.