Why does the price of a put or call option on a stock drop a lot on the previous month's options expire day?

Question

I've been watching put and call options on GOOG, and last Friday was expirations day for JULY options, and on that day, the prices of all the AUGUST options dropped a lot, much more than was justified by the stock price change. Both puts and calls dropped, and I can't figure out why. Thanks for any insight.

Answer 1

It's time decay. And option has 2 types of value - time value and intrinsic value.

Intrinsic value is the value of an in-the-money option. For example, let's say you have a call option on XYZ Corp. at 50 and the price of XYZ Corp. is $52. The option has an intrinsic value of $2 ($52 stock price minus 50 option strike price).

On a put option, if the strike is 50 and the stock price is $45, the intrinsic value is $5.

Time value is the portion of the options premium that is relative to the amount of time left till options expiration. All options have time value built into them. But the time value decays till the day of expiration and when the option expires there is absolutely no time value left. If the option is in-the-money, all that is left is the intrinsic value. If the option is out-of-the-money, there is neither time value nor intrinsic value so the option will have expired worthless.

The closer the option gets to the expiration date, the less and less time value the option has, but is not a uniform decay pattern like 2% a day. The further out the option is, the slower the time decay. The closer the option gets to expiration, the faster the time decay. The time frame where the option loses time value the fastest is the time from from 6 weeks thru 2 weeks before the option expires. When the July's expired, there was only 4 weeks left on the Aug. options.

Also, the greater the certainty about an options expiry value, the lower the time value and vice versa.

So, if there was a major drop in the Aug. options right after the July's expired, that can be attributed to the Aug. options being in the time range of the fast rate of time value decay and also probably that the market is pretty sure what the value will be when the Aug. options expire.

Answer 2

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Answer 3

Interesting observation.

If I had to guess why, I'd say that perhaps people are either unwinding old calandar spreads or putting on new ones. This could cause selling pressure on the new current-month option.

Answer 4

So keep watching a plotting graphs, then jump on it. Just watch that the broker doesn't get all your profit with fees.