Option Time Decay | Strategies to Take Advantage of This Option Greek

Options time decay is one of the most important concepts that any options trader needs to understand. This "greek" affects every option trade and can be used to your advantage if you know how to use it. This blog post will discuss what options time decay is and how you can use it to make more money in your trades!

Market Moves Matt

Mar 23, 2022 - 15:06 Updated: Mar 30, 2022 - 18:19

0 932

Option Time Decay | Strategies to Take Advantage of This Option Greek

Option Extrinsic vs. Intrinsic Value

When you buy or sell an options contract, you are essentially paying for the extrinsic and intrinsic value. The intrinsic value is simply the difference between the strike price and the underlying security's current price. For example, if you buy a call option on XYZ stock with a strike price of $50, and XYZ stock is currently trading at $60, your intrinsic value would be $60 - $50 = $10.

The extrinsic value of an option is the other piece of the puzzle you are paying for when buying an options contract. This is the "time value or time decay" of the option, and it decays as we approach expiration. The extrinsic value is affected by many factors, but the two most important ones are the expiration time and the implied volatility of the underlying security.

Option Intrinsic vs. Extrinsic Value Example

In the example below, we can see that the price of the SPY is $445.46. Therefore, if a trader were to buy the $445 strike option, this would be considered an "in the money option." Below is a breakdown of the extrinsic and intrinsic value of an option.

Intrinsic Value: Subtracting the stock price by the strike price of the call option.

$445.46-$445.00 = $0.46

Extrinsic Value (time value or time decay): Subtracting the intrinsic value from the price of the call option.

$3.56-$0.46 = $3.15

Option Intrinsic vs. Extrinsic Value

This means that the option will only have $46 of intrinsic value at the expiration but will cost the trader $356 from the time value. Most traders pay a premium for options where 80-90% of the value will erode.

This is the problem option traders are facing and the most significant reason most will fail. So let's dissect this problem a little bit more and then present some strategies that can allow traders to profit from this option greek.

Options Decay Explained

As we stated earlier, the extrinsic value comprises two factors: expiration date and volatility. The closer we get to the expiration date, the less time there is for the price of the underlying security to move and, therefore, the less valuable the option becomes. This is known as "time decay" or "theta."

The other factor that affects the extrinsic value is volatility. High volatility = high extrinsic value, low volatility = low extrinsic value. This makes sense when you think about it because the more volatile a security is the more likely it is to make a big move in the options prices than a less volatile one. Therefore, options on more volatile securities are more expensive than options on less volatile securities.

Time Decay Explained with

Many greeks are factored into the option's price. For example, options time decay, or theta, relates to the amount of value an option can lose every day. Most brokers will present this data to traders on the platform to be well aware of the risk from the option being held.

This percentage daily loss can be extremely high; that is why most traders will reference theta before entering the trade.

Example of Time Decay

The example shown earlier for the SPY was using the Robinhood trading platform. When the user clicks an option on the option chain, "the greeks" can be displayed.

The example below shows that this option has a theta value of -0.52, which refers to a $52 loss of option premium every day.

Given the cost of the option, this is a 12% loss, which is exceptionally high! Traders must know these numbers BEFORE entering the trade.

time decay example

Time Decay Effects on Strike Price

Theta (time decay) generally gets more prominent the further the option is considered "out of the money," which refers to a call option being over the stock price or the put option being under the stock price.

The chart below paints a good picture of how the "moneyness" of the option relates to the time decay of an option with one day till the expiration date.

The stock price for this option chain is $445, so anything to the right is considered out of the money, and anything to the left is considered in the capital.

Here are the key takeaways from the data:

Time decay accelerates further and further the strike price is away from the stock price.
Time decay is unavoidable. Even "In the money" options still have time decay.
As these are options with one day till the expiration date, the numbers may be lower percentage-wise, but the concept still applies as we travel further out of the money.

strike price vs time decay chart

Time Decay Effects on Expiration Date

Theta generally gets more significant the closer the option is to the expiration date. This is because options within 30 days of the expiration date can decay exceptionally quickly and be quite dangerous to traders.

To illustrate just how quickly this time decay can increase towards the expiration. The chart analyzed only five options with a strike price at the money, but the time decay is minimal right up to the 30-day mark.

A zero-day option at the money option, the time decay got as high as 15%! This number can be even more significant given the options volatility and how close the option is to the strike price.

days til expiration and time decay

Advantages of Time Decay

Now that we know why time decay is dangerous for options traders, let's discuss the flip side. There is an option seller for every option buyer, which means the option contract we discussed earlier that was losing 12% per day in value was gaining 12% per day in value for another person.

An option seller is referring to an investor who shorts an option. The goal for the option seller is for the option to lose value which will allow the seller to repurchase it for a profit. In some cases, the option seller will look for the option to lose value completely.

Many option sellers make a full-time income from this well-known fact using many common option selling strategies we will discuss next.

Options Strategies for Time Decay

Cash-Secured Puts

A cash-secured put is where the option seller collects a premium by selling put options. The goal is for the stock to stay above the put strike price, so the option expires worthless.

cash secured put

Covered Calls

A covered call is where the option seller owns shares of the underlying security and sells call options against those shares. The goal is for the stock to stay below the call strike price, allowing the option seller to collect the entire premium from the option short.