Options Time Decay

Image Source: Pexels

There are a few things in life that are constant, and time is one of them. Though when it comes to the options world, not all time is created equal. This article will discuss options time decay and explore the relationship between theta and gamma.

Theta refers to the decline in an options price due to the passage of time. Options have both intrinsic and extrinsic value. The intrinsic value of the option is the value the option would have if it were exercised today. The extrinsic value is the price of the option minus the intrinsic value. This is our time component.

For beginners, it is easy to think of theta as constant. This is incorrect. As long as an option has extrinsic value, it is true that time decay will occur. Yet the rate of that time decay varies drastically, as shown in the graph below.

options time decay chart

In this chart, we have the values for three options with one month to expiry. The blue line represents an ATM (at-the-money) option, the red line for an OTM (out-the-money) option, and the green line is an even further OTM option.

We may notice a few things. We will begin by looking at the blue line. The theta decay will continue to accelerate until the day of expiration where, if the option is still ATM, the theta will be at its greatest (red circle). Conversely, we may notice that the green line for the far OTM option has the opposite shape. It is also downward sloping, but the slope flattens over time.

Theta decay is at its highest initially and then steadily declines as the option loses value. At the black arrow, theta decay is minimal. The reason for this being that the option has already lost almost all of its value and is trading for pennies. Theta decay is highest for options ATM close to expiration and highest for far OTM options furthest from expiration.

Theta vs. Gamma 

If we are selling options, we are initially drawn to the shorter-dated ATM options. These have the highest theta decay. Yet time decay is not a free lunch. The theta decay is what we collect if the stock doesn’t move, and gamma is what we pay when it does.

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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are ...

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