Put options: Time decay vs charm decay

Options trading can be complex, with many interplaying factors impacting pricing and profitability. Two of the most important concepts for put option traders to understand are time decay and charm decay. While related, these decays behave quite differently. Mastering the nuances between time decay and charm decay is critical to maximising profits and minimising risks as a put option seller or buyer.

Understanding time decay

Time decay, also known as Theta, is one of the most influential forces in options trading. Time decay refers to the declining value of an option as it approaches its expiration date. All other factors being equal, an option will lose value as time passes due to the reduced window for the underlying security to make a meaningful price move.

The impact of time decay accelerates as expiration nears. Options far from expiry may only exhibit minor daily time decay. However, in the last 30 days or less, time decay rapidly erodes the remaining premium. Right before expiration, time decay vastly outweighs other pricing factors.

Time decay impacts the extrinsic value component of an option's premium. Extrinsic value represents speculative value driven by volatility expectations. As expiration approaches, there are fewer days for volatility to potentially emerge, reducing this extrinsic component.

Time decay is exponential - it accelerates as expiration nears. On a daily basis, at-the-money options may only lose a few cents of value due to time decay alone. Deep out-of-the-money options will exhibit even less daily time decay. But in the last weeks before expiration, the value lost per day ramps higher rapidly.

Strategies around time decay

• Sell options with 1 month or less until expiration to maximise daily time decay.
  
• Avoid buying long-dated options; the premium slowly decays versus stock ownership.
  
• Roll option positions farther out in time to "reset" and minimise time decay.
  
• Buy options when major events are near (earnings, SEBI decisions) so time decay is muted.
  

Read More: What is time decay and does it have any impact on your investments?

Understanding charm decay

While time decay consistently erodes option value, charm decay behaves quite differently. Charm represents how much an option's Delta value changes given a 1 point move in the underlying security. Charm decay occurs when charm becomes less responsive to underlying price changes over time.

An option’s charm tells you how sensitive its delta is to the underlying asset price. Delta measures expected option price movement per ₹1 change in the underlying. If a put option has a Delta of -0.50 and charm of -0.10, a 1 point underlying drop would decrease Delta from -0.50 to -0.60. The option price would react more strongly. When charm decay happens, Delta becomes less responsive to price moves. Using the same example, if charm decayed to -0.05, then a 1-point underlying drop would only move Delta from -0.50 to -0.55. Charm decay reduces the impact of charm over time.

What causes charm decay?

The influence of time decay is a primary driver. As time passes, extrinsic value decays, which dampens charm's responsiveness. When substantial time value remains, charm is reactive since perceived volatility risk is high. But as expiration nears, charm decays or flattens out.

Charm decay is most noticeable with at-the-money options. Here, charm is most responsive to underlying price changes initially. But extrinsic value decay flattens the charm slope such that Delta moves less and less per ₹1 change. Deep in or out-of-the-money options have little charm sensitivity to begin with, so charm decay is minimal.

Strategies involving charm decay

• Sell options with low charm sensitivity to minimise volatility risk from charm decay.
  
• Hold options with significant remaining time value to sustain responsive charm.
  
• Buy options with nearby expirations since charm is already decayed.
  

Comparing time decay vs charm decay

Predictability - Time decay is steady and predictable. Charm decay fluctuates randomly based on price moves.

Pacing - Time decay accelerates near expiration. Charm decay is inconsistent, depending on volatility.

Profits - Time decay always benefits option sellers. Charm decay can help buyers or sellers depending on situation.

Positioning - Time decay favours all expirations, especially near-dated. Charm decay matters most for at-the-money options.

Hedging - Hedging time decay requires rolling positions outward. Hedging charm decay involves managing Delta sensitivity.

Conclusion

Time and charm decays exert meaningful but very distinct effects on options pricing. Time decay is the predictable erosion of extrinsic value as expiration approaches. In contrast, charm decay reduces Delta’s sensitivity stochastically over time. While related in involving the passage of time, these forces differ substantially in terms of behaviour, strategies, and implications. Traders must evaluate time and charm holistically to maximise profits while minimising risks.

With the knowledge provided in this article, you now have a strong foundation for applying time and charm decay effects to your options trading. Just remember - time decay accelerates exponentially whereas charm decay is inconsistent. Incorporate both decays into trade planning and adjustment to master option Greeks management.