You might have observed that the option prices suddenly change near expiry. Many beginners don’t understand it, and they get shocked when the option they bought loses value rapidly, even when the underlying asset doesn’t change much. This is due to the behaviour of options pricing changes near expiry.
If you are an option trader, it is very important to understand how option premiums change during the final days or last few hours. This will help you make informed decisions and manage risk. We will explore the influence of various factors on the options pricing.
What Determines Option Price?
An option’s price (premium) is made up of two main components:
1. Intrinsic Value
Intrinsic value is the real value of an options contract. A call option will have an intrinsic value if the underlying asset’s price is above the strike price. Similarly, a put option will have an intrinsic value if the underlying asset’s price is below the strike price. Out-of-the-money (OTM) options have zero intrinsic value.
2. Extrinsic Value
The extrinsic value is also called time value. Extrinsic value represents the probability of future price movements within the remaining time till expiry. Some key factors influence this value:
- Time to expiry
- Implied volatility
- Underlying price movement
- Interest rates
Extrinsic value declines significantly as the expiry approaches. We will see how these factors behave near expiry.
Theta Near Expiry
Theta, also known as time decay, measures the rate of change of an option’s price due to the passage of time. Theta is not linear. It increases exponentially, due to which in the early part of the options’ life, time decay is very slow, but during the final days, time decay becomes rapid.
Theta acts fastest on ATM (At-The-Money) options. OTM options can quickly decay to zero. And ITM options are less affected by the theta as they have intrinsic value. This is one of the most misunderstood concepts among beginners, and it is usually explained in detail in advanced online option trading courses where traders learn how time decay accelerates closer to expiry.
Implied Volatility Near Expiry
Implied Volatility (IV) is the expected future price movement for that particular option. Although the impact of IV is reduced near expiry, major events may cause the IV to rise and then collapse after the event.
Also, as the expiry approaches, there is less time for big moves. Therefore, IV has a smaller effect compared to time decay and price movement.
Gamma Effect Near Expiry
The rate of change of delta is known as gamma. Gamma increases significantly near expiries, especially for ATM options. Small movements in the underlying asset can cause large price swings, which create an opportunity and risk as well.
A small move in the underlying on expiry day can cause sharp changes in ATM option prices. However, time decay causes the options premium to drop rapidly if the price remains unchanged.
Conclusion
There are various factors that act on an option’s price. Due to which the behaviour of an option changes as it approaches the expiry. Gamma increases price sensitivity, ATM options lose value quickly, and time decay accelerates. Implied volatility becomes less valuable.
Prior to trading short-dated options, it is essential to comprehend the behaviour of the options price. Although expiry trading has a lot of potential, there is also a lot of risk involved. To learn more, enroll in an option trading full course from Upsurge.club.
