How Does Time Decay Work?
Time Decay, which is also known as Theta is an option seller’s best friend. It is the amount of money a seller makes per day on an option.
Option time decay is denoted by using the Greek word Theta. Theta is one of six indicators in option trading known as the Greeks.
Options are a decaying asset. Option time decay 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. That makes sense because the more time left in the trade, the greater the chance that the underlying (stock) can move.
This is why I like to refer to selling options as “Selling Time”.
As time passes, the options you have sold lose value. For any option trade you do, whether you are buying or selling options, you can determine the theta value of the trade.
If you are long theta, you can make the amount of theta per day if the stock does not move. For example if the theta value of your trade is 100. Your trade will increase in value $100 per day if the stock does not move. By looking at the theta of a trade you can get a good idea of how fast the options are losing value on a daily basis.
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. The closer to expiration, the faster the decay. That is why we normally prefer to sell options with less than 2 month to expiration.
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 in time 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 60 days to expiration.
Every day that goes by brings an option one day closer to expiration. One day closer to the end of the trade. The amount of value an option loses on a daily basis is its Theta.