What does time decay options also known as theta mean? It measures the rate of the decline of an options contract with the passage of time. Options contracts are decaying assets that have an expiration date. Time eats away at an options contract each day that goes by. It is a widely discussed fact that the majority of options contracts expire worthless. Below we’ll talk about how decay plays a role in bringing down the value of an options contract.
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What Is Options Time Decay?
Theta, or time decay options, measures the risk that time has on an options contract. Time value is important because options expire. Options lose their value as the expiration date approaches. To put it simply, theta measures how much value an option losses every day as it gets closer to the expiration date. This is why an option can sometimes be called a wasting asset. With each passing day, value leaves.
In this article we are going to look at time decay options and their meaning. Investopedia defines time decay as the ratio of the change in an option’s price to the decrease in time to expiration. Since options are wasting assets their value declines over time.
Stock options contracts give the buyer the right but not the obligation to buy or sell at a specific price. A bullish play is a call. A bearish play is a put.
The purpose of am options contract is to predict which way the stock will move. You can buy an option at a lower value than the stock and sell at a higher value for a profit. Trading options is a great way to make a living.
A lot of options buyers, especially new ones, buy calls and puts. Calls and puts have limited risk and unlimited profit potential. But in doing this you’re missing out on many of the benefits of options trading.
Expiration
You can put time decay on your side with options. Theta affects the value of the options contract. As the expiration date of an option approaches, it’s easier to predict the value of the contract. Options contract sellers collect time value premiums. These are paid by the options buyer.
Time decay options sellers can benefit from the time passing even if the contract is not moving. This is because time decay will affect profits when an option is in or out of the money.
The Greeks
Options have something known as The Greeks. Lets consider them an options trading fraternity. There are 4 Greeks known as Delta, Vega, Gamma and Theta. They are statistical values that measure risk. There are 4 Greeks known as Delta, Vega, Gamma, and Theta. Focusing on the Theta due to the topic of time decay. Understanding time decay is important when selling options; this is a great way to use theta to your advantage.
The Enemy Known as Father Time
Father Time comes for all of us. When long on an option the time decay will be negative. That is when you need implied volatility and the stock price to change.
If they do not get executed and are not in the money by the time of expiration. This is known as the option expiring worthless. Out of the money options are typically the options expiring worthless.
When an option is out of the money for a call, the strike price is higher than the stock price. When a put option is out of the money, it’s strike price is lower than the stock price.
You’re looking at the option time decay curve. Intrinsic value + extrinsic value = option’s price. Break out the option time decay calculator! Time decay falls with the passing of days affecting the outcome of the option price.
Buy or Sell?
When you buy a time decay option, you’re on the hook for the Theta time decay. There are time decay options strategies you can use. All options contracts begin equal.
The higher the theta is the faster your options are losing value. But it’s ok to give yourself time on your time decay option. If you purchase an option with an expiration date that is a ways away, you can sell it much sooner at a profit.
Theta is low when an options contract with an long expiration date isn’t going to move fast. The theta moves faster the closer to expiration an option gets.
Now if you sold (which means you’re short) an option a decrease in time is a good thing. The option is less valuable so it’s cheaper for you to buy back at a lower price (closing the position).
As stated earlier, the seller benefits from time decay options. If you short a stock, you’re borrowing shares from your broker to “buy back” when you cover the position. You could buy a put and time decay can be a negative factor. Or you can sell a put and let the time decay work for you.
Don't Be Afraid
Time day options can seem scary. There’s a lot of information to take in and it can be overwhelming. Make sure that you practice paper trading options. There are a lot of strategies you can follow. The good thing is there are a lot of moving parts with options. The more you study the more prepared you’ll be when you begin trading options. If you need more help, take our options trading course.
Frequently Asked Questions
Every option has a different rate of decay due to the theta. The delta of an option contract measures the speed. Options are decaying assets so each day that passes the more the option decays.
