The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation. Options trading involves unique risks and is not suitable for all investors.
Options traders can potentially make money in the market when one of two things happens: when their long option goes up in value, or their short option goes down in value. If their option moves in the opposite direction, then they lose money. The same is true of spreads, which are made up of more than one leg, but one must look at the net value of the trade.
Don’t confuse this with what you want the underlying stock to do. For instance, if you’re short a put, you want the underlying to go up, which should lower the value of your put, thus allowing you to either buy it back for a lower price, or allowing the option to expire worthless.
What exactly is it, then, that makes option prices (and therefore spreads) go up or down in value? As we’ve covered in a previous Swim Lessons article, the Greeks can help us quantify the relationship between an underlying stock and its option prices. Delta and Gamma relate to the movement of the underlying. Vega relates to changes in implied volatility, and Theta addresses the inevitable loss in value that options experience as time passes.
Of all these, the passage of time is the one thing that’s certain. Time marches on, which means that most option prices will continue to “decay,” or lose value over time. And if an option is going to lose value over time, then it’s possible to profit from that option by shorting it.
*Note that the other Greeks are playing a part in how option prices change, but we’ll assume everything remains the same for the purposes of this article.
Theta Decay: Why am I Melting?
If you buy an option, your Theta value is negative. Theta decay is one of the (few) consistencies that option traders can rely on. Long options lose time value as they near expiration date. In fact, the rate of Theta decay accelerates the closer you get to contract expiration. However, if you’re short an option, time is on your side, so to speak, as your Theta value is positive.
Take a look at the option chain in figure 1. You can set up your option chains to display the Theta amount of each option by clicking on the column header, selecting Option Theoreticals & Greeks, and then Theta.
FIGURE 1: OPTION CHAIN.
See the Intrinsic, Extrinsic, and Theta values. Chart source: thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
What you see is how much value the option will theoretically lose on a daily basis from the time decay. For instance, the 25-strike call in figure 1 shows a theoretical decay of $0.07 per day. The 28.5 strike call, which is out of the money (OTM), has a theoretical decay of only $0.03 per day. That makes sense because as an option approaches zero, it can’t really decay any further.
But, then, why does the 22-strike call only have $0.03 of decay if it’s worth about $3.17? The value of an option is broken down into two components: intrinsic value and extrinsic value. Intrinsic value is the difference between the stock price and strike price of an in-the-money option. It’s also the amount the option would be worth if it was exercised today. Extrinsic value is the difference between the option’s premium and the intrinsic value.
For example, in figure 1, the 22-strike call, with the stock at $25.07, the intrinsic value is $3.07. The remaining amount, which is about $0.10, is the extrinsic value. And it’s the extrinsic value that tends to decrease with the passage of time.
You’ll also notice that time decay is not the same for every strike. At-the-money options have the highest rate of decay. As options move either OTM or ITM, the rate of decay drops and approaches zero. Also, shorter term options decay faster than longer-term options. This rate of option decay speeds up as the options get closer to expiration.
And it’s these two facets that traders put to work when seeking to profit from strategies such as short OTM vertical spreads, iron condors and calendar spreads. Even though these strategies all involve long options that experience time decay, if the trade goes as planned, then the short options bring in more than the long option loses, to net out a profit. But if there’s an adverse move in the underlying, like when a short OTM spread moves into the money, then the net time decay of the trade works against you.
In a nutshell, utilizing strategies that seek to profit from the inevitable decay of options is one way of putting time on your side and increasing your probabilities as a trader.