Hey everyone.
This is Kirk, here again at Option Alpha.
In today's video, we’re going to cover once again option time decay or as it's more commonly
known as the Greek Theta in option pricing models.
Simply speaking, option time decays is really easy to understand once you wrap your hear
around it.
For stocks, stocks don’t have any time decay feature to them because they have no expiration
period.
You can theoretically buy a stock and hold it for 50, 60 years if you want to and so
long is the price that it’s at now is higher than where you bought it, you can make money
on it.
Very simple, very easy to understand, that’s why a lot of beginners get into stock trading
as opposed to options trading right off the bat.
Now with options, you have another added feature to your trading parameter or your trading
strategy.
Not only do you have to guess the correct direction of the market, whether you’re
buying puts or selling calls or buying calls and selling puts, whatever it is, but you
also have to guess how fast the market will move.
And this adds another layer of complexity to options trading, but it’s very easy to
understand once you wrap your head around it, this whole concept of time decay.
And it basically just means that the option is going to lose value every day that it doesn't
meet that strike price or hit that strike price.
We’re going to quickly take a look at some pricing sheets here for options trading early
in the morning.
And I’ll just go back to my Thinkorswim platform which you can now see.
It's about Friday, 8AM here are on the East coast, so the markets haven’t opened yet,
so these are pretty stagnant prices as of right now.
But I think it drives home (like some of the pictures in the post) some of the features
of time decay.
You’ll notice here that I’ve opened up two separate contract months (this is for
the SPX or the S&P 500 index) and you can see there's February 2011 contracts which
have 27 days and then I also have opened up the March contracts which have 55 days, so
you can see 55 days until the last trading day.
These February contracts since they have a shorter lifespan are actually going to lose
value much quicker than these March contracts and I’ll show you just a minute how much
value is left at different intervals.
Let’s just take for example these easy calls right here.
These are the 12.90 February calls.
And you can see under the Theta category here, the T, Theta that these calls have negative
Theta of .34.
If we look down at the March ones, you can see that the same exact strike price just
one month out has a negative Theta of .26.
Basically what this means is that these February options are going to lose about $.34 per contract
every day just based on time decay.
If the market were to stay completely flat that day, they’d lose $34 even though the
stock went nowhere.
On these March options, you’d lose a little bit less.
You’re still losing money because the contract is getting one-day closer to expiration, but
you’re losing just a little bit less money every day.
We understand that definitely the option contracts with a month further out have less time decay.
And even just for the sake of simplicity, if we go out to the April's which have 83
days, you can see they have just a little bit less.
Now, we know that time decay speeds up exponentially as we get closer to expiration.
Now, the other thing I like to show people all the time is this difference between intrinsic
value and extrinsic value.
We know that intrinsic value is value of options that are in the money, so that’s why there’s
a breakout in this shaded region.
An intrinsic value never changes.
It's not based on any time decay volatility factor.
You can see that for example, for these February 12.80 calls, the intrinsic value is $.26 and
the same thing for these March 12.80 calls as well.
Now, the extrinsic value is the value that's left to time decay and that's this higher
feature here.
For these March 12.90 calls, it’s 24.40.
And for these February 12.90 calls, it's 14.95.
You can see there's less value for options that are closer to expiring and to this whole
theory of time decay that the option will lose value as we get closer to expiration.
Now of course, it works in the same category over here in the puts, just in the opposite
direction.
Okay, I hope this has been a great video.
And as always, please email us with questions or comments.
And happy trading!