Option Time Decay: How Does it Work?
What is option time decay and how does it work in the context of stock options? Option time decay is denoted by using the Greek word theta. Theta continues to be one of six indicators in option trading known as the Greeks.
Options are a decaying asset. Option time decay is a feature of all options that basically means that an option will lose value as time goes on and it gets closer to expiration. So when you are looking to buy an option, the more time until expiration means the more the option will cost versus an option that has less time to expiration in which the underlying can move.
Option Trading and Value VS Time
Theta specifically measures the sensitivity of an option’s value according to the passing of time. Another way of saying this is that theta is the ratio of change in an option price according to the fleetingness of time before the expiration. An easy way to remember this principle is to think of options as living assets that are wasting away as they age. The value of an option naturally declines as time goes on. If an option is fast-approaching the expiration date and is not ITM (In-The-Money) then its value will quickly decline, since it’s highly unlikely it will turn out to be profitable.
Option time decay really starts to pick up speed in the last 30 days before expiration, assuming that the option isn’t already OTM or Out-of-The-Money). How about options that are deep In-The-Money? Ironically, in this case time value actually decays even more rapidly. Why? Probably because the market thinks these options are too expensive to hold especially when compared to other strike prices. Therefore, holders of deep ITM options are wise to discount the time value (for a contract quickly approaching expiry) in order to attract new buyers. The best way to remember this principle is this: the more certainty about an option’s expiry value you have, then the lower the time value is. Likewise, the more uncertainty as to the option’s expiry value, then the greater the time value you get.
When to buy selling options?
This is an important part of choosing when and where to buy selling options. Theta or option time decay is not precisely the same thing as Time Value, though they are related in thought. The meaning to take home is basically that the time to expiration will have a major impact on the price of the option. As the option comes closer to expiry then its chances of becoming more profitable are actually decreasing, and counting against it.
Besides, predicting a stock price eventually becomes easier as every day passes and seems to resemble the last. Therefore, it’s the time value that is decreasing as maturity approaches (and particularly so once past the 30 day mark). As the option ages, it loses what is called extrinsic value.
For an OTM contract, the option trade is made up of extrinsic value anyway, so understanding this time principle is paramount.
When trading options, the amount of time left for an option is what can make or break you. Look at a chart of a stock moving in an uptrend and you can tell it is going higher, but you cannot tell how high it will go and by when. If buying options, buy yourself enough time to be right on your bet.
When selling options, selling close to expiration limits your risk. The farther away from expiration you sell, the more premium you get but you do not get the quick decay benefits of option time decay until there are less than 40 days to expiration.
This is why I like to refer to selling options as “Selling Time”. As time passes, the options you have sold lose value. Making money while sitting around. Not a bad job if you can get it. And you can, if you sign up for my service. 🙂
So what do you think? I’d love your comments so please leave one.
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Why not then buy only LEAPS for one year, where you have reason to believe the stock will rise over the next four to six months, rather than buy the stock ?
LEAPS still have to deal with theta decay. But they are an alternative to stock if you only want to be in a trade for a few months. The trick is to know which strike to buy.
Another thing is the Delta on leaps is lower than closer months as the closer months are more likely to expire in the money. So the closer months move more $ per $ with the stock . example – AIG 30 call delta is .7575 for the Feb 2011 and the Sept 2010 is .8455
How does theta decay work with spreads?
Great info. I will be joining next months newsletter. What is a good percentage of total assets to set aside for adjustments and how often do they happen? Thanx robert
Robert, you will get direction on that once you join. The money for adjustments is accounted for as part of the total account. I uses $10,000 as an example account and do not use more than that.
genius,can u explain how options time decay works, u only talk about 30 ,40 days. by the way cote me if iam wrong, selling option require bigger account ??? and most broker will not allow selling i ira accounts
correction : ” in weekly options”
Time decay works similar in weeklies but at a much more rapid pace. That is why you really cannot adjust a weekly trade very much. its like trading options on speed.
Watch the theta of the trade. If you are long option see how fast the theta increase. the theta will tell you how much value the option will lose.
Is there a site which identifies misplaced options ( by that I mean difference between market price and coresponding theoretical value?
Not sure. But I bet you could figure it out for yourself. You’d have to look at historical volatility and compare it to implied and do some math, but it could be done. Then have a programmer write you a script that you could use on a trading platform like thinkorswim, tradestation, etc.
I certainly appreciate the way you explain the various parameters of an option and the trading of such. Both the buying and selling of these instruments. You obviously have a concise understanding of this subject for I was once told if someone cannot explain the subject in terms that you understood then the expert does not truly understand the subject themself.
Thank you very much!
What options brokers do you recommend up here in Canada
Anyone that will allow you do do the strategies you prefer will do. Ameritrade, Schwab, Etrade, Interactive brokers, and TradeStation, they all are great.