All option buyers have one common enemy, Father Time. Option expiration is one of the few certainties we can find in this world of financial markets. When buying an option, you are betting that the market will move in a certain direction within a certain amount of time. When pricing out anything that involves time (i.e. life insurance policies) the time portion of the option can be quantified. A ‘theta’ is the value we come up with based off how much time is left on an option. Below, we can see a chart with a breakdown for how each option position’s theta is priced. A negative theta means the position will lose value due to time decay, while a positive theta means the option will make money due to time decay.
|Short Call Option||Positive|
|Long Put Option||Negative|
|Short Put Option||Positive|
Theta is an estimate of how much an option would decrease per day from time decay when there is no outside movement or volatility in the underlying futures contract. Long puts and calls always have negative time decay, and short puts and calls have positive time decay. The higher the theta is on an option – priced between -1 and 0 for long options and 0 and 1 for short options – the more value will come out of the option per day when all else is constant. Keep in mind that the theta seldom stays constant; it can move quickly depending on where the option’s strike price is relative to the underlying futures price. At the money options tend to have higher thetas and are more susceptible to time decay as expiration approaches. The thetas are progressively lower for options as you get away from the strike price at the money. Option decay is not linear, it is exponential and increases as the option gets closer to expiration. The chart below shows a timeline of the rate at which time value comes out of an option.
Time Value Erosion
There are ways to profit from time decay. One of the most effective strategies that aims to do this is the Iron Condor or individual credit spreads. These strategies give the ability to capture time decay with a set amount of risk. The theta on the option sold will be higher than the thetas on the option purchased. So, if the option spread expires worthless you will keep the profits. Let’s look at an example:
Dirk is an option trader who wants to sell option premium in the E-mini S&P 500. He has a hefty stock portfolio and wants to use his futures account as a way to hedge some downside risk he is exposed to in his stock portfolio. He also wants a strategy that is relatively short term that has a set amount of risk. Dirk feels bear call spreads are a method to do that because they would provide a limited amount of risk. They would also only lose money in his futures account when his stock portfolio made money, a tradeoff he wouldn’t mind. He will use the theta of each call to quantify to the best of his ability how much theta he can capture. Since we have 35 days left in the August E-mini S&P options he feels those are the best to use. He calls his Daniels Trading broker and takes a look at the August 1340-1370 call spread while the futures contract is trading at 1310. His dt Broker executes the following trade:
Potentially, his max profit will be $550 and his max loss will be $950 before fees. We add the thetas together to see that the time decay on this option spread at these levels is .13. If the market stays at a constant the spread value will decrease 13% on this day. He can recheck these theta calculations daily to keep an eye on how much he will make each day from time decay. Dirk’s plan is to apply one of these spreads every month at a certain distance away from the current S&P price. In his mind, this is could be a win-win strategy because it’s possible he either makes money in his futures account or makes money in his equities account. He doesn’t plan on liquidating his mutual funds or stocks anytime soon, so he figures he might as well attempt to make some profits from time decay along the way.
For more information on the Greeks and different strategies to profit using their characteristics, or to find out more information on hedging within your portfolio please contact your Daniels Trading broker.
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