By: Steve Smith
While the market seems to grind higher every day, it can still be buffeted by coronavirus-spread headlines, the pace of economic recovery, and fiscal policy stale.
This has made trading a bit herky-jerky, especially in options where the value’s impacted by price and sudden volatility shifts.
For this reason, I’ve shifted my trading strategies and Options360 positions to focus on credit spreads, such as iron condors, and into stable names like Apple (APPL) that provide good liquidity-making adjustments and income extraction through premium collection easily.
I’ll likely maintain this approach for the remainder of 2020. So I thought it would be good to cover why getting time decay is such an important and powerful part of options trading.
But, as an options trader, one thing that never stands still is time. Learning how to harness time decay (options theta) can be a powerful tool for producing consistent profits. Let’s take a look at how it works.
Time’s a key component in an option’s valuation. Thankfully, it’s applied equally to all options regardless of the underlying security. However, there’s one nuance that needs to be understood. In the options world, time curves — accelerating as expiration approaches.
Anyone that’s ever been on a deadline can certainly relate. And theta’s our tool for defining time, measuring the rate of decay in the value of an option per unit of time.
There’s a basic math formula used in the Black-Scholes model that’s a good starting point. Basically, we use the square root of time to calculate and plot time decay. The math involved in the nitty-gritty of evaluating theta can be extremely complex, so focus on this: Time decay accelerates as expiration approaches, meaning that theta is defined on a slope.
For example, if a 30-day option’s valued at $1.00, then the 60-day option would be calculated as $1 times the square root of 2 (2 because there’s twice as much time remaining). So, all else being equal, the 60-day option’s value is $1.41, or $1 times 1.41 (1.41 is the square root of 2). A 90-day option would be $1 times the square root of 3 (3 because there’s three times as much time remaining) for an option value of $1.73. (1.71 is the square root of 3).
Notice that the 60-day over the 90-day premium’s ($0.32) less than that of the 60-day over the 30-day ($0.41). So again, the important takeaway is to realize that the closer an option is to expiration, the time value decay rate gets faster.
This graph makes the math easier to visualize and shows that rates of decay are different depending on if an option’s in-the-money, out-of-the-money, or at-the-money.
Here are some other basic concepts you need to know about theta:
- An option’s theta can be calculated as follows: If a particular option’s theta is -10, and 0.01 of a year passes, the option price’s predicted decay’s about $0.10 (-10 times 0.01 is 0.10).
- At-the-money options have the highest theta. Theta decreases as the strike moves further into the money or further out-of-the-money. In-the-money options are mostly composed of intrinsic value (the difference in the option’s strike price and the market price of the underlying), while out-of-the-money options have a larger implied volatility component.
- Theta’s higher when implied volatility is lower because high implied volatility suggests that the underlying stock’s likely to have a significant price change within a given time period. A high IV artificially expands the life of the option’s time remaining, helping it retain value.
Time’s always moving. In our daily lives, some days seem to pass quicker than others. So too with options.