We prefer tosince we are convinced that the market over-prices risk as shown by versus realized volatility. For this, an understanding of option decay and that different options decay differently is very important. We’ll examine how works and how in-the-money (ITM), at-the-money (ATM) and out-of-the -money (OTM) options decay differently and why.
An additional risk factor when holding options in a portfolio is that they are a decaying asset. This time risk (theta) is the risk that an option will expire worthless. Since options have a defined lifespan, theta represents the theoretical decrease in value due to each passing day.
Key points to remember about Option Decay:
- OTM/ATM options decay in value because there is a lower expected payoff for the option at expiration with each passing day.
- OTM options are more likely to expire worthless and ATM options are more likely to expire with less value.
- ITM options decay in value as they move closer to parity with the underlying (less extrinsic value).
- Long options have negative theta.
- Short options have positive theta.
ATM option decay accelerates asapproaches, particularly around the 45 DTE mark, which is why we look to establish short premium trades in this time frame.
On the other hand, with OTM options, theta becomes less negative in the final days before expiration., the rate of change for delta, increases as expiration nears.
Watch this segment of “Options Jive” with Tom Sosnoff and Tony Battista for the valuable takeaways and a better understanding how different options decay and how it influences strategy selection.