Theta Time Decay – Key Points About Selling Options Part 8
Theta Time Decay – Key Points About Selling Options (Part 8)
Let’s flip into the Greeks and look at what it means to have Greek positions from the sell side. And what kind of exposures are there. First, Theta; this is the most important one. I’ve mentioned time decay a few times previously, Theta is the Greek measure of time decay. You can look this up and it would be expressed in decimal form representing a cash number of the expectation, all else equal of how much the option will lose value from one day to the next. and I stress, all else equal. Or here it says all other pricing factors stay constant. As I said before the stock can move around in different directions and that Theta, that time value, can disappear and come back. But all else equal you can look up the amount that you would expect the option to lose from one day to the next.
Calls and puts both have negative Theta amounts, that’s just the option themselves because they’re losing value. We’re on the sell side, so our position should be positive Theta. Owning options means you’re losing from one day to the next as that gradual decay of options occurs, but from the sell side our positions will be positive Theta, and if you have more than one short option, you can just simply add them together. If you’re looking for an estimation on what is my position, my Theta position overall from one day to the next its arithmetic. Add up all the thetas and see what the net amount is. Selling options has positive Theta, and this is a look at how time decay occurs.
It’s not the same for ‘at the money’ and ‘in the money’ options, because first of all ‘in the money’ options have far less time value to begin with. ‘In the money’ options just gradually gravitate towards parity or gravitate towards their intrinsic value. So, it’s rather a slower more linear decay for ‘in the money’ option. Same thing with and without the money options. But, ‘at the money’ is different. You’re at that 50 Delta level right exactly where the stock is trading, your strike price and stock price equal to each other. Those options don’t decay very quickly until you reach about six weeks or so until expiration. And that’s where that that arrow is pointing in that rough gray area around 40 to 45 days until expiration.
When the acceleration of time decay begins to increase, option sellers are trying to capture that time value, so it’s less likely to see sellers go out much further beyond that six to seven week time frame. You certainly could do it and if you go further out in time you’re actually capturing more premium. The further out you go, the higher the dollar amount is going to be, but the rate of decay as you go out beyond that time frame of six weeks or so is going to be slow. And then once you get to 45 days, it picks up and as you can see the acceleration of decay continues to increase all the way to and through expiration. On this curve, as you reach expiration, while the acceleration of decay is increasing the open market value of the option is decreasing with less time to expiration. So, choosing your expiration date to open the position is weighing those two considerations. How fast is the acceleration of the decay? You want as much of that as possible, and how much can I get for the option? Those two things have to be balanced. They don’t work hand in hand.
The closer to expiration the greatest rate of decay, you’ll get the lowest premium amounts. So, you’ll have to decide where the sweet spot is for you and it’s probably going to be different from one trade to the next. Also, one other thing to point out is where is Theta just in general? Where is it? The greatest? Is it the greatest ‘at the money’? We just covered that. It’s also greatest for near-term options, as you go out further in time, it’s slower and slower and slower. So, for Theta it is greatest at the money and near term. We can look through the different Greeks as well, but first some numbers on Theta just to see why it’s important to visualize how this can be. Looking at Theta amounts with different expiration dates on the left. We have stock at $50, fifties on both sides, but the implied volatility levels different and these are ‘at the money’ options with 20% implied volatility. You can just see, as you go from the 365 days to expiration one year out all the way down to five days, the Theta continues to increase and the option premium amount gets smaller and smaller and smaller.
You’re going to get an incredibly quick amount of decay there at five days. But, a smaller amount of actual premium, if the stock never moves in this option ends up at zero, you can make more money possibly by selling that shorter-term option. But what if it doesn’t move? What if it actually moves a bit lower? Maybe you’re a bit bearish when you sell this particular option, if you do it out right. Well, then in that case selling the option further out with higher premium is going to be a bit more profitable. So, you can see how that differs and from the left to the right going with 20% implied volatility up to 40% implied volatility. You can see how that certainly just about doubles the premium and that can really highlight the effect of implied volatility.