(tpreston): Good afternoon everybody
(tpreston): Thanks for coming
(tpreston): Today I'll go over some basics about time decay
(tpreston): I'll cover some material in about 20 minutes, then open it up to questions.
(tpreston): Options are one of the most time-sensitive financial instruments.
(tpreston): At some point, options expire. And at expiration, all extrinsic value is gone.
(tpreston): That constant loss of extrinsic value is known as time decay, or theta.
(tpreston): Theta is an estimate of how much the theoretical value of an option decreases when 1 day passes and there is no change in either the stock price or volatility.
(tpreston): Positive theta means you make money from time decay. Short options have positive theta.
(tpreston): Negative theta means you lose money from time decay. Long options have negative theta.
(tpreston): You can see each option's theta by going to the TRADE page and selecting theta from the information layout menu in the upper right hand corner.
(tpreston): But theta doesn't reduce an option's value in an even rate. Theta has much more impact on an option with fewer days to expiration than an option with more days to expiration.
(tpreston): For example, the IBM Jan 04 95 call has a theoretical value of $3.80, has 100 days until expiration and has a theta of -.02.
(tpreston): The IBM Oct 95 call has a theoretical value $.85, has 9 days until expiration and has a theta of -.08.
(tpreston): If one day passes, and the price of IBM stock doesn't change, and there is no change in the implied volatility of either option, the value of the IBM Oct 95 call will drop by $0.08 to $.77, and the value of the IBM Jan 04 95 call will drop by $0.02
to $3.78.
(tpreston): Theta is highest for ATM options, and is progressively lower as options are ITM and OTM.
(tpreston): This makes sense because ATM options have the highest extrinsic value, so they have more extrinsic value to lose over time than ITM or OTM options.
(tpreston): The theta of options is higher when either volatility is lower or there are fewer days to expiration.
(tpreston): If you think about gamma in relation to theta, a position of long options that has the highest positive gamma also has the highest negative theta.
(tpreston): Theta only works in your favor when you are short options.
(tpreston): Let's look at some positions that take advantage of time decay.
(tpreston): Short out of the money verticals
Long at the money time spreads
Long at the money butterflies or condors
(tpreston): They all make money if the stock doesn't move very much. And they all have trade-offs.
(tpreston): The reason the short OTM vertical makes money from time decay is that the short call has a higher theta than the long call because the short call is closer to the ATM.
(tpreston): Ideally, the short vertical will expire worthless.
(tpreston): If you short a vertical that is far OTM and that has a high probability of expiring worthless, you won't collect as much premium as if you short a vertical that is closer to ATM, but that has a lower probability of expiring worthless.
(tpreston): As the short OTM vertical approaches expiration, its value gets close to zero, say .05, and its theta gets very close to zero as well.
(tpreston): At that point, you have to balance the extra .05 you would make if you stay short the vertical versus the possibility that the stock goes against you and turns a winning trade into a losing trade.
(tpreston): It's a trade-off of risk vs reward.
(tpreston): The reason the long ATM time spreads make money is that they have short front month options, which have higher theta than the long back month options.
(tpreston): The more time between the expirations of the short option and the long option, like short Oct and long Jan 04, the greater the positive effect of time decay.
(tpreston): You also have the ability to roll the short month to the next month, for example from Oct to Nov, and from Nov to Dec, to collect more money from time decay.
(tpreston): But that position is going to have more sensitivity to changes in volatility, which is bad if vol drops.
(tpreston): You can reduce the risk of volatility by selling Oct and buying Nov, but you won't collect as much money from theta.
(tpreston): The difference in theta between Oct and Jan 04 is greater than the difference between Oct and Nov.
(tpreston): The reason the long ATM butterflies and condors make money is that they have short ATM options, which have higher theta than the long ITM and OTM options in the position.
(tpreston): ATM butterflies really don't start making money until the last week before expiration.
(tpreston): But in the last week before expiration, the short options in the ATM butterfly and time spreads have very high short gamma to go along with the high positive theta.
(tpreston): The high positive theta comes with the drawback of high negative gamma, which can wipe out any profits from theta if there is a big move in the stock.
(tpreston): That's why you might consider closing a profitable butterfly or condor before it expires. For example, if your long 5 point ATM butterfly is worth $3.00 a few days before expiration, you might want to sell it and take your profits.
(tpreston): Even though it could make another $2.00 for you if the stock settles at the middle strike at expiration, the butterfly could go to 0 if the stock moves dramatically.
(tpreston): You have to balance the potential extra profits with the possibility of the butterfly going worthless.
