Options trading is multi-dimensional. It’s much more complex than buying stock expecting it to go up or selling short stock expecting it to go down. Because options involve a specific strike price and expiration date, they have both an intrinsic value (what the option would be worth if exercised right now) and extrinsic value (the added value that comes from time and volatility). Here, we discuss Theta decay, the time component of the extrinsic value calculation.
You probably know that Theta declines as time passes, you may not know that Theta does not decay in a straight line. Because Theta is not linear, it is the most powerful options trading concept you can use.
What is Theta decay?
Theta is what is known as one of an option’s “Greeks.” Greeks are used to understand how sensitive an option is to factors that go into its pricing. At a basic level, these factors are the price of the stock, the strike price of the option, time, volatility, and interest rates.
Theta is the value that quantifies how the option price changes as time (and ONLY time) passes. All things equal, if one day passes, an option will lose value. This means that if you are long an option, your option will be worth less tomorrow than it is today. Conversely, if you are short an option, you will be able to buy that option back tomorrow at a cheaper price.
This is Theta decay: the decay in the price of the option as time moves forward.
Of course, time isn’t the only thing that moves. Between today and tomorrow, the price of the stock will change, as may the volatility of the stock. These factors will all go into the “new” price of the option and, ultimately, whether you have a profit or a loss.
However, by isolating Theta, you can strategically position yourself so that you are insulated from or capitalizing on Theta decay.
How does Theta decay change?
Theta decay changes as the time to expiration grows nearer. If you think about it, this should make sense. The passage of one day out of 365 days is a smaller percentage than the passage of one day out of 30, which is also a smaller percentage than the passage of one day out of 5.
Therefore, it makes sense that the passage of one day on a LEAP option may not erode as much of the option’s value as the passage of one day on the nearest weekly option, assuming the strike price and underlying price of the stock are the same.
OK, so we should understand this from a common sense perspective.
Below is an image for how that decay looks visually for at-the-money options. Between each of the periods of time, the option loses more and more of its time value.
As the curve shows, most of the erosion in the time value of an at-the-money option comes in the final 30 days (left part of the chart), while there is very little erosion 120+ days out (right part of the chart).
Headwind vs. Tailwind to Your Options Strategy
That gives you either a powerful tailwind or headwind with a potentially gigantic difference in performance.
Let’s say that you are bullish short-term on Apple’s current stock price ($127). There are numerous ways to express that bullishness, both in terms of strategy and strike price. The at-the-money strike is selling one week out for $2.30, bringing the break-even price to $129.30. All of that option’s price is extrinsic value which will vanish in the next two weeks. If the stock price doesn’t change, that option will be worth $0—its current intrinsic value.
However, an in-the-money option doesn’t have such a steep Theta decay. The $120 call for the same date is trading at $7.55, bringing the break even to $127.55 and suggesting just $0.55 of extrinsic value in the price. If Apple’s stock price doesn’t change, this $120 call loses just $0.55, becoming worth $7 instead of $7.55.
All things the same, it would be better to give up $0.55 to Theta decay than $2.30.
In that way, buying the at-the-money option one week out is like flying into a headwind. While you’re still flying into a headwind with the $120 option, you have less decay just from time passing.
However, if you reverse this, you can see how Theta becomes a powerful tailwind to your options strategy. If you want to do a stock replacement strategy because you are bullish on Apple for the long-term, you may purchase the six-month $105 call for $27. (This is the 80 delta call, which is our preferred stock replacement strike.)
This at-the-money call is going to have very little Theta decay because it is farther out in time.
Then, this week, you can sell the $127 call and collect $2.30. Since you have a high delta call, your overall position is still bullish. If Apple’s stock price goes higher, you will participate on the upside. If it goes sideways, then you will collect the Theta decay of the short option. And if it goes down, the decline in price will be offset by the amount collected on the short call.
Over the next six months, you can continue to do this with the weekly at-the-money calls when appropriate. That’s what we at Market Rebellion call a tailwind.