Time Decay and Theta

March 1, 2010

Time decay of options is a major factor to be considered when purchasing an option contract. Time decay of options, for puts and calls, is such that every option will theoretically lose some of its value every day.  The reason for this is that options have a limited life. The Greek term Theta is used to describe time decay of options.

When buying a call option, the option buyer bets that a market will move higher within a certain amount of time. When buying a put option, the option buyer bets that a market will move lower within a certain amount of time. The key term is “time”.  Options have limited time and therefore suffer from time decay.  The effect of time decay or theta will vary depending on a variety of factors; however, time decay always exists when you buy an option.  It does not matter if the option is a put or a call. Time decay affects puts and calls.  As an option buyer, you have to be correct on the direction of the market, as well as the timing of the move. Otherwise, the option will expire worthless.

In the simplest of examples, if you buy an option for $300 dollars, and that option has 30 days until it expires, it will theoretically lose $10 every day (assuming the market remains unchanged).  Note that the rate of time decay (Theta) increases as the options expiration date comes closer.

Note that if you are long options, your position has negative time decay (negative Theta).  If you are short options, the position has positive time decay (positive theta).  Many people avoid selling options, as doing so incurs significant risk and that risk can be unlimited (the risk is similar to being long or short a futures contract).  Being long options has the benefit of having limited risk and unlimited reward potential.

It is possible to trade options as a spread and construct the puts and calls such that the overall position has positive time decay (positive theta).  In most cases, these trades have limited risk and limited reward, but the trade off is that the position avoids negative time decay.  Also note that not all option spreads have positive theta.  One must carefully select the right options, strike prices and expiration months in order to produce a positive theta.

This related post shows an example of how to construct a directional trade with positive theta or positive time decay.

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