Time Decay: Tick-Tock
Apr 20, 2018
By: Sage Anderson
When dealing in options, a paramount aspect of every trading decision involves time until expiration. At tastytrade, we often refer to this factor as "days-to-expiration," or DTE for short.
A simple example can be used to illustrate just how significantly time to expiration factors into every trading decision.
Imagine stock XYZ is trading for $50. Now picture the value of the XYZ $50-strike call with one week until expiration versus the value of the XYZ $50-strike call with one year to expiration. Without even knowing where the market is trading, it's easy to see how the value of the one-week option would trade for substantially less than the one-year option.
The underlying price of XYZ will have a lot more time to fluctuate in value over the course of one year as compared to the course of one week - theoretically increasing the potential range of the stock.
Time decay (or theta decay) is an industry term often used to describe the declining value of an option as time passes. Time decay is such a critical part of trading options that one of the “Greeks” is dedicated to providing insight on this specific parameter - a metric known as “theta.”
Theta is the Greek that reports how much an option theoretically decreases in value with the passing of each day. For example, if you purchase a call option for $5 and the theta of the option is $0.50, then it will theoretically lose $0.50 of value for each day that passes. After two days, assuming no movement in the underlying, the option will be worth $4.
The concept of time decay perfectly frames the ongoing struggle between option buyers and option sellers. Option sellers hope that movement in the underlying remains muted, with the goal of keeping as much of that theta (the credit received) as possible through expiration.
On the other hand, option buyers are typically cheering for a big move in the underlying (or at the very least an increase in implied volatility), which in turn could theoretically boost the value of their long position.
If you are trading a portfolio with multiple options positions, you may also be managing time decay at the portfolio level. Strategically, this might include targeting an absolute level of daily net theta (whether collecting or paying) that matches your outlook and strategic approach.
For example, you might have five long options and five short options, but your overall theta may be positive (meaning you are net collecting). Whatever your approach, it's important to keep in mind that different types of options possess slightly different theta characteristics.
At-the-money (ATM) options, for example, have higher theta numbers (all else being equal) because there is greater extrinsic value in ATM options. This makes sense because ATM options are more "in-play" than options which are deep in-the-money (ITM) or far out-of-the-money (OTM).
As a reminder, the value of an option can be broken down into both “intrinsic” and “extrinsic” value. Options with intrinsic value are always in-the-money (ITM) - intrinsic value is equal to the difference between the current value of the underlying and the strike price of the option.
For example, imagine that stock XYZ is trading $50, and the $45 strike call is trading for $6. The difference between the underlying price and the strike price ($50-$45 = $5) equals the intrinsic value, which is $5. The remaining portion of the option’s value ($6-$5 = $1) is referred to as the extrinsic value ($1).
Intrinsic and extrinsic value are important when discussing theta because it’s the extrinsic value of an option that is affected by the passage of time. Whereas the intrinsic value (or parity value) of an option is dictated by the price of the underlying and the strike price - not time.
Another important point to keep in mind is that as expiration gets closer, the rate of theta decay speeds up. All else being equal, the steepest theta decay generally occurs with 5-7 days until expiration. While this may increase our theta-per-day collections, one must also keep in mind the double-edged sword of risk and reward.
With additional potential reward (higher theta per day) also comes additional potential risk. As short premium positions approach expiration, exposure to potential big moves in the underlying intensifies. If a big move does occur near expiration, there’s very little (or no) time left for a tested position to recover.
The above highlights why theta and time decay are so critical to any options trading endeavor. Decisions related to buying and selling premium, as well as the length of time a position is held, can all be tied back to balancing risks and rewards related to time decay.
If you're interested in learning more about these topics, the tastytrade website contains a wide range of content focusing on time decay and theta. The links highlighted in the bullet points below may serve as a good starting point:
If you have any questions about time decay or theta, we hope you’ll leave a message in the space below, or reach out directly at email@example.com.
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.
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