Theta and Time Decay

Theta and Time Decay

Time Decay and Implied Volatility are two key considerations in the option trading decision making process.

Stock options have limited life spans. As an option nears its expiration date it loses time value. Understanding this loss of time value, allows us to increase the probability of seeing profits in our option trading.

Theta Decay Reflects Diminishing "Time Value"

The theoretical measure of how much time value is being lost is measured by "theta," which is derived from the options pricing formula. When you buy an option, it will have a negative theta because that option is losing time value each and every day. Conversely, a short option position will have a positive theta. With each passing day that option is losing value to time decay. This loss of value allows you to buy-to-close your short option position at a lower cost.

The Effect of Theta Decay Upon an Option

For a long option position to increase in value, value lost to theta decay must be offset and outpaced by favorable price movement of the underlying security and/or substantial increases in implied volatility. If you do not see a favorable price move, theta will erode the value of your long stock option position.

Theta decay is not linear, however. An option with many months of time value will see very slight erosion due to time decay. As expiration approaches, theta decay begins to accelerate. The most pronounced time decay occurs in the last weeks prior to expiration.

Theta Decay: Is Time on Your Side?

Expiration is never a surprise. We always know precisely when an option is going to expire. Because expiration and time decay are certainties, a favorite strategy of many option traders is to be a net seller of option premium.

There is a 100% probability of an option losing 100% of its time value. By selling an option and holding the short position to expiration, you will only lose money if that option expires in-the-money.

Strategic Stock Option Selling

In general, option sellers prefer selling at-the-money or out-of-the-money contracts with less than 60-days remaining until expiration. The goal of these option sellers is to collect a small amount of premium and then allow theta decay to erode the position.

Because theta decay is inevitable, consider maintaining a positive theta in your portfolio. All other things being equal, your portfolio will see a net appreciation in its assets due simply to the passage of time.