Capiche? The Downside of Selling Time

Some things, like fine wine and denim, get better with time. Lots of other things just age. The time premium of an options contract falls into the latter category. It decays from inception to expiration.

Theta measures the time decay on an options contract’s value. Although positive theta is considered a good thing, how many times have you executed an options trade with positive theta, only to find your anticipated profit and loss (P&L) never comes to fruition? When you execute an options trade, you know how things stand at the moment: price, theta, implied volatility, and so on. But the next hour, day, or week may bring a different story. Anything could happen to change the value of an option significantly and send your P&L astray.

Reality is Stranger than Theory

An options contract’s extrinsic value is subject to theta. But theta’s value doesn’t just depend on time. Theta is a theoretical number that indicates what price might be if implied volatility (IV) and price remained equal. But in reality, that never happens; markets are always changing. And although theta can impact the price of options, so can IV and price movement. So even though your risk curve may look ideal when you execute your trade, it’s not going to include “unknowns.” Focus on the information you have. Just keep in mind it’s valid only for that moment.

Another general theory is that time decay may have less impact when an option has more time to expiration. As an option gets closer to expiration, the rate of decay goes through a rapid decline. (Again, in reality, it may not be as clear-cut.)

You Can’t Look at Theta by Itself

The time, or extrinsic, premium of an option has to do with theta (time decay) and vega or volatility (vol). When you add vol into the mix, pricing dynamics change. Higher IV can mean higher options prices. And the rise in IV can cause the rate of time decay to increase.

To see how theta and vol impact options prices, fire up your thinkorswim® platform from TD Ameritrade. Figure 1 shows an option chain where IV is around 50%. The 305 puts with seven days to expiration (DTE) have a theta value of -0.48, whereas the puts at the same strike with 35 DTE have a theta value of -0.24. Nothing surprising here—theta for options closer to expiration tends to be higher. 

Figure 2 shows an option chain with an IV of around 10%. Theta values are much lower. The 165 puts with seven DTE are at -0.10, and those with 35 DTE are at -0.06.

This is how theta works on single options. For spreads, theta’s impact could be less. Either way, these values can change at any time. So regardless of what the P&L looks like, you still need to anticipate uncertainties creeping in and changing the entire scenario. 

Theta can be helpful in evaluating how the price of the option might change over time. However, don’t count on it until you’ve closed the trade.