Time decay is a term used to describe how the theoretical value (time value) of an option reduces, or decays, with the passage of time. Theta, one of the so-called “Greeks,” measures the rate of change in an option’s theoretical value for a one-unit (usually one-day) change in time to the option’s expiration date. Theta thus measures time decay – the decrease in an option’s time value due to the passage of time.
An option’s intrinsic value of course does not decay with time; it changes only with movements in the underlying stock’s price.
Theta usually is expressed as a negative number since it has a negative (inverse) effect on the option’s price. A theta of -0.01 indicates that the option’s time value is falling one penny every day.
The adjacent chart illustrates that time value is slow to decay early on, accelerates in the last 30 days and accelerates even more in the last 10 days.
One who buys the an option with less than 30 days to expiration sees the sand (time value) run out of the hourglass very quickly! If the option also is highly overvalued due to volatility expectations caused by a pending event – discussed further on in this chapter – then a buyer of the option is poised to lose serious time value premium even if the stock price doesn’t change a penny! Here’s how this happens:
- Theta steals a little of the option’s value every day.
- A collapse in the market’s volatility expectations will also collapse the option’s price.
How do we actually use theta? Option buyers and sellers view it very differently.
Option buyers should be well aware that theta steals time value at the highest rate in the last month before option expiration – as illustrated above. For this reason, the canny option buyer will purchase the option shortly before the expected stock move and close in a few days if the move does not take place – or close earlier if the stock moves the “wrong” way for the option purchased. Otherwise, the time value portion of the premium will literally disappear by expiration. As noted earlier, time is not the option buyer’s friend.
However, when an option trader feels quite sure about a stock’s direction but is unsure of its timing, buying an option several expiration months out can make sense. The reason is that theta does not take a huge part of the option’s value each month on longer-term options.
Option sellers, on the other hand, really like theta. Covered call writers tend to sell calls in the current month (30 days or less to expiration), perhaps even in the last couple of weeks before expiration. The reason of course is that theta accelerates so much in the last month. The option’s loss of time value in the last weeks makes it possible to sell calls 30 days from expiration and then close them profitably during expiration week at a profit due to the option’s fall in time value from, yep, theta.
Theta offers scant advantage for the sale of longer-dated options, because they lose value each day at a glacial rate until the last month. This is why most covered call writers tend to write the current month, and it’s why covered call books teach them to do so. Of course, there are reasons to sell longer term calls, covered further on in this book, but they do not revolve around exploiting option theta.
Be aware of the interplay between theta and delta. Longer-term options usually have much lower deltas than the same strike options expiring in the current month, but they will also have much less theta – lose value very slowly. Buying current-month options gives us higher delta for most strikes, but also higher theta and very fast loss of time value.