Options 101: Understanding Time Decay
One of the only pitfalls of trading options is that they lose value the closer you begin to get to an expiration date.
Remember, options are a decaying asset. That rate increases the closer you hold as your expiration date nears. If you’re in a call or put, and the move hasn’t happened in a respectable time frame, jump out and move to the next trade. Time decay is also referred to as theta, or a measure of the rate of decline in the value of an option over time.
For example, let’s say I wanted to pick up the AMD November 17, 2017 12-call option, as of November 7, 2017. With 10 days to go before this option expires, even if I buy it at 46 cents, time decay issues will strip me of 0.0273 each day until expiration. Plus, that rate of decline will only speed up the closer I get to my expiration date of November 17, 2017.
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We can see this referred to as Theta with the AMD November 12 call option.
At the same time, I can pick up an AMD December 15, 2017 12-call option for 84 cents with several weeks prior to expiration. Theta for this particular option is only 0.0140 per day. An AMD April 20, 2018 12-call has a theta of 0.0067.
The closer we are to expiration the higher the theta. The further we are to expiration the lower the theta. This is something to be very well aware of any time you trade an option.
Theta isn’t the only “Greek” to be aware of though.
- Delta tells us how much an option will change every time our stock moves up $1.
- Gamma tells us how much the delta can increase every time the stock moves higher.
- Theta is time decay. It will tell us how much our option price loses every day. For every day you hold an option it will lose value. That’s just how it is. Nothing in life is without risk. Theta tells us that our call option will lose just over three cents at the moment. This will speed up and get bigger as you near expiration.
- Vega tells us how much an option price will change on moves in volatility.
- Rho tells us how much options will change with interest rates. No one really pays much attention to rho any more. The rate of change here doesn't move much.
In a nutshell, each Greek allows us to calculate potential rewards.
It’s something to be well aware of as you trade options.
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