An option loses time value through its life and becomes zero at expiry. This loss in time value, referred to as time decay or theta, is perhaps the most important component to be mindful of when you initiate long option positions. This is because time decay is a loss, not a risk, as we have previously pointed out in this column. This week, we examine whether futures has time decay.
Interest component
Futures price is typically greater than its spot price. The difference is the interest component embedded in the futures price. If you buy the underlying, you must pay the total amount immediately. But if you buy a futures contract, you must pay only at expiry. Note that the futures valuation model does not consider initial margin and market to market margin. Even if these margins are considered, the capital you require to initiate long futures position is substantially lower than what you need to buy equivalent shares in the spot market. So, what do you do with the remaining trading capital? The valuation model assumes that you earn interest on it. This interest component explains for the futures price being greater than the spot price.
Now, futures have a delta close to one. That is, futures price will move almost one-to-one with the underlying. Any difference in the price movement between futures and the underlying can be attributed to the demand for futures being different than the demand for the underlying. That said, futures price will converge with the spot price at expiry.
The aforesaid point leads to an interesting argument. If the delta of the futures contract is close to one, then there must be little or no time decay on futures. Yet, the difference between the futures price and the spot price will become zero at expiry. Suppose futures trades 8 points above the spot, you will lose the 8 points if you hold the futures contract till expiry. But this need not be the case any time before expiry. So, unlike options, which loses time value with each passing day, futures do not.
Conclusion
Think of the interest component as a compensation to the short futures trader for not paying the entire value upfront. So, interest component (also referred to as the cost of carry) is an opportunity cost. In the case of options, you lose time value because the probability of the option ending in-the-money (ITM) reduces with each passing day. This also impacts the option delta. The above argument is important for trading. When you expect the underlying to trend slowly, you may choose to initiate a futures position. This is because of its delta being close to one. With options, the sooner the price target is achieved, the better. Also, the initial margin you pay for futures is towards the final contract value. In contrast, you pay the strike price if you exercise the option, which is in addition to the option price.
(The author offers training programmes for individuals to manage their personal investments)