Guide to Theta and Time Decay
Jul 6, 2018
I read recently that the band Journey will be headlining at Summerfest this summer in Milwaukee. While the band harkens back to a different era, nobody can argue that their Greatest Hits album is timeless - much like The Cars Greatest Hits album.
And while you may have a different taste in music, pretty much everyone has a "greatest hits" album they like to put on during the summer with the windows rolled down in the car - pure bliss...
It’s a fitting theme for today's blog post because a recent episode of Options Jive would certainly be included in "tastytrade's greatest hits" if such a compilation were ever created.
The show focuses on theta and time decay, and is notable due to the method by which these concepts are seamlessly woven together.
What makes the episode particularly powerful is the way it combines a wide range of concepts - such as theta, probability of profit (POP), and time decay - in a way that really drives home some of the key concepts of options trading.
While a sneak-peak of the material will be revealed in this blog post, we think the material packs a much bigger punch when reviewed in its entirety - so we hope you'll do so when your schedule allows.
Getting back to the episode, the hosts start off by reminding viewers that option contracts are decaying assets, meaning their value naturally decreases over time. That reality creates a theoretical opportunity for option sellers, and a risk for option buyers.
The metric that provides insight into this natural decay in an option contracts theoretical value is theta, as illustrated in the graphic below:
Due to the concept of time decay (detailed above), there's a natural pressure that builds on long options to perform. Unless the underlying makes a big move, or implied volatility rises dramatically, a long option simply can't produce a positive return.
That means, generally speaking, that short option strategies have a probability of profit (POP) that is above 50%, while long option strategies have a POP below 50%.
The respective POPs derive from the fact that short premium approaches are typically positive theta, meaning the trader collects time decay on a daily basis. On the other hand, long premium approaches are usually negative theta, which means they bleed theta, which is why their POP is lower than 50%.
The exhibit below helps illustrate the above mechanics:
The above shouldn't be interpreted to mean that short premium positions will win on every occasion. There's risk inherent in every trade, which is why the POP is never 100%.
However, it is also important to recognize the different dynamics of risk vs. reward when evaluating potential positions. Trading decisions are of course also dependent on market conditions, as well as a trader's unique risk profile and outlook.
As we've only highlighted a snapshot of the guide to theta and time decay today, we hope you'll review the aforementioned episode of Options Jive in its entirety when your schedule allows.
If you want to learn more about time decay, you can also check out this previous blog post.
Lastly, don’t hesitate to leave any feedback or questions in the space below, or reach out directly at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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