On Friday we took a look at an option pricing model called 'delta'. This model illustrated that an option price may or may not change on a dollar-for-dollar basis with any price change of the underlying security. The lesson to be learned was simply that, when setting price targets for options, you had to understand how much of a price change was likely for any corresponding change in the underlying stock. Today we'd like to continue on with something we touched on Tuesday, and discuss how the option price can change even if the underlying security doesn't move at all. This change is called time decay, or 'theta'.

As a quick review, let's go over delta again, and why it's important. Delta is the dollar amount that the premium (price) of an option will change for every dollar change in the underlying security. In our example, we saw that the QQQ's May 36 call option had a delta of 61.5. This meant that if the QQQ's moved higher by one dollar, then the call option would move higher by about 60 cents (remember, options are only priced in nickels and dimes). This is highly important to option traders who may be predicting only a dollar move for the QQQ's. If the QQQ's did indeed move up by one dollar and the May 36 call option moved up by the expected 60 cents, there's no point for the investor to continue holding the option - he's gotten all the gain he's going to get. On the other hand, a trader who was not aware of the delta figure may be waiting around to get the full dollar-for-dollar change. Unfortunately, he may be waiting for something that's just not going to happen. Worse than that, by continuing to hold the option, he risks an adverse reversal, which may wipe away what gains he had. That's why at least understanding delta is important.

But what if the underlying security doesn't change at all? Would the option price still change? Absolutely! Remember from Tuesday that the two main influences on option prices were time left until expiration, and how deeply in the money the option was (in other words, 'risk').  Even if the stock price doesn't change, the time until the option expires will always be shrinking. This takes its toll on the price of an option. Why? Think of it like this: three months ago when the market was rocketing higher, we would have thought nothing of paying $5.00 for ourQQQ May 36 call option, since it looked like the QQQ's would be well over $36.00 by this point in time. Obviously this did not happen, as the QQQ's are now struggling to even stay above $35.00. Would you pay $5.00 today for an option that is barely in the money, and going to expire in less than a month? No way! The May 36 call has a lot less speculative value now than it did then, and the price indicates that. That's the nature of time decay.

So how do we know the true impact of time decay on our option? The answer is 'theta'. Theta measures the daily decline in option prices simply due to the passage of time. For example, if theta equals .11, that means that each option contract loses $11 per day (remember, 1 contract = 100 shares, and 100 shares x .11 = $11). Obviously a high theta can work against you, even when you were right about the direction of the underlying security. This brings us to the point of our two-part TrendWatch. Being right about the direction of the stock is not enough; you must also overcome time decay (theta) and less-responsive (low delta) option pricing. (continued below)

So how do we do this? The answer may surprise some of you who have been trading barely-in-the-money and near-expiration options. These lower-priced options look like bargains at first glance, but the theta is so high and the delta is so relatively low for them, generating a profit is excessively difficult. You may often find that the better opportunities lie in deeper-in-the-money options that are not on the brink of expiration.

For example, the QQQ May 36 call we mentioned above has a delta of 46.0. Theta for this option is -0.04 (meaning, a 100-share contract loses $4.00 every day just due to the passage of time). The QQQ's would have to increase by four cents every day just to break even! Throw in a commission of two cents per share on a contract you can only sell for about $0.85, and you can see that you've got a lot of factors working against you. Plus, you only have a few days left for your QQQ prediction to become a reality.

On the other hand, the QQQ July 36 call has a delta of 50.0 (it's 4 cents more responsive than the May call), and its theta is only -0.01. This option has 1/4 of the time decay of the May call! Plus, you have an extra two months for the QQQ's to move in your favor. And let's face it - the market is volatile, but the QQQ's can move a lot further in three months than they can in a month. And even the impact of a two-cent commission is halved, since the option sells for $1.60.

The bottom line is this: the larger percentage-return opportunity may seem to be in the lower-priced, near-expiration options. But the cost of time decay, relatively high commissions, and a limited lifespan can hurt you. The longer-term, deeper-in-the-money options have a lower theta, are still responsive, and commissions aren't nearly as detrimental. Plus, you have more time for the market to move in your favor. Be sure to weigh these risks and rewards when choosing which option to buy.

Price Headley is the founder and chief analyst of BigTrends.com, which provides daily stock and options recommendations and education.