Welcome back to our Introduction to Options series!
By now we’ve covered:
Now, we’re going to explore another critical factor in options pricing: time
You're about to learn:
This article is somewhat technical in nature.
You don’t need to understand all the math.
You certainly don’t need to know this formula:
So just focus on learning the basic principles, and you'll be a step ahead of options traders that fail to grasp the role of time in options.
In our recent article on implied volatility, we identified the 7 basic factors that determine an option’s price:
While implied volatility is the most important factor in an option’s price, time is a close second.
Remember what we said about options — they’re a form of insurance.
A call option is an insurance contract that pays off when the stock rises.
And a put option is an insurance contract that pays off when the stock falls.
And like a car, the faster a stock moves, the higher it costs to insure it with options.
But what else affects the price of insurance?
Would it cost more to insure your car for 1 year?
Or 2 years?
Obviously, you pay more for 2 years of insurance coverage than 1.
Because over a 2-year period, there’s a much greater chance of something happening than over 1 year.
And so it goes with options: the longer the time to expiration, the higher the price of the option (insurance).
Let’s take a look at Facebook (FB) $175 call options across a wide range of expirations. As of the time of publication, the stock was trading at $176.46.
Here are the prices for all FB $175 call options that are currently trading. They have expirations ranging from 2 to 793 days from today:
As you can see, the $175 call option expiring in 2 days is priced at just $2.
The option expiring in 93 days costs $9.61.
And the call option expiring in 793 days costs $32.10!
Because again, options are a form of insurance. And it’s only logical 793 days of coverage costs more than 2 days of coverage.
Remember what I just said about our Facebook example.
793 days of coverage costs more than 2 days of coverage.
And you know what?
793 days of coverage also costs more than 791 days of coverage… and 790 days of coverage, and 789 days of coverage… and so on.
So all things being equal, options lose value as time passes.
And theta is a measure of how fast that loss of value happens.
Theta is simply a reality of the world of options trading.
And it's a concept you have to understand if you want to make money with options.
Plus, there are strategies that actually take advantage of theta, though they are beyond the scope of this article.
At publication, the Facebook $175 call option expiring in 9 days is currently priced at $3.18.
The stock is trading at $176.46.
This means there is a premium of $1.72 built into the option.
This is calculated as the strike price + the options price – current stock price, or $175 + $3.18 – $176.46 = $1.72.
The amount of premium built into the option is affected by implied volatility and other factors.
The higher the implied volatility, the higher the premium.
Theta, or time decay, is the dollar amount by which this premium declines each day.
You can find the theta of an option on virtually any trading platform.
Theta is displayed as a negative number, typically without a dollar sign.
So if you see a theta of -0.10, that means the option will decline by $0.10 per day, all things being equal.
(we use dollar signs in this article to reinforce the fact that it is indeed a dollar amount)
The theta for our Facebook $175 call expiring in 9 days is -$0.12.
This means that if Facebook’s stock doesn’t move at all, it will be worth $0.12 less tomorrow, or $3.06.
And that’s why time is an option’s kryptonite.
If the underlying stock or ETF doesn’t move, the passage of time will reduce the value of your option.
Theta continually changes.
And the closer an option is to expiration, the faster it loses value.
Here is the theta for our Facebook $175 call options by each expiration:
As you can see, the option expiring in 2 days has a theta of -$0.16.
And the one expiring in 793 days has a theta of just -$0.02.
This is a simple illustration of one of the most important concepts in options: the closer an option gets to expiration, the bigger the theta is.
Think of of it this way: if an option expires in 9 days, each day accounts for 11.1% of the time left to expiration.
And if an option is expiring in 793 days, each accounts for just 0.13% of the time left to expiration. So it's not going to change much.
Now, let’s look at the theta table one more time, because there is an exception to the rule that the closer an options gets to expiration, the bigger the theta is.
As you can see, the option expiring in 16 days has a theta of -$0.15, which is bigger than the -$0.12 theta of the option expiring in 9 days.
This is because Facebook will report earnings in between days 9 and 16, so the options expiring on Day 16 have a high implied volatility.
The higher the implied volatility, the higher the theta.
That means more premium that gets eaten away by theta.
At-the-money options have the highest theta, and thus the highest amount of money to lose through time.
Options that are in the money have a lower theta because they are largely comprised of intrinsic value, rather than premium.
And out of the money options have a lower theta because they have so much less premium to lose in the first place.
There are some exceptions to these rules, particularly with extremely far in and out-of-the-money options, but you should rarely if ever be trading those options anyway.
Here is an example using Apple (AAPL) options expiring in 30 days. At publication, Apple was trading at $160 on the dot, putting the $160 call perfectly at-the money.
As you can see, the $160 call has theta of -$0.07, making it the highest in our example.
We know that as time goes on, all things being equal, options lose value due to the passage of time
And as time goes on, the rate at which options lose value accelerates.
So when we buy an option, we’re speculating that the option will rise in value at a rate that offsets time decay.
Let’s take an example using the iShares Russell 2000 ETF (IWM).
At the time of publication, IWM was trading at $149.87.
The December $150 call expiring in 58 days is currently trading at $3.11, and has implied volatility of 13.3%.
We’re going to assume that everything stays the same, except the number of days to expiration.
According to the CBOE’s options calculator, if 28 days pass and the ETF is still at $149.87, the options price would be just $2.29.
That’s a loss of 72 cents, or 36%.
And if IWM was still at $149.87 with 10 days to expiration, the $150 call would be worth just $1.28
That’s a loss of $1.83, or 59%.
Assume IWM rose to $152 with 10 days to expiration.
The option would only be worth $2.60 for a loss of 51 cents, or 16%.
Because the stock didn't move enough to offset the impact of theta.
Throughout this article, we’ve discussed how the passage of time eats away at the value of options.
But remember what we said in our introduction to options article: options are a zero sum game.
When someone is winning, someone else is losing on the other side of a trade.
Since time decay pushes down the value of options and punishes options buyers, it benefits options sellers.
So if we bought IWM calls and lost 16% because of time decay, someone would be gaining 16% — the seller of the option.
They're short, so they're profiting from the drop in the option's value.
Shorting options is incredibly risky, and we don’t recommend shorting options “naked.” (naked shorting means shorting a call or put option without an offsetting position to limit the risk of the trade)
However, we want you to understand the mechanics of the market, which is why we're explaining it.
Again, you don’t need to understand the nitty gritty of the mathematics to successfully trade options.
But you must understand the three basics options principles illustrated in this article:
Sadly enough, most options traders don't understand these concepts.
So by learning them, you're getting a step ahead of the crowd!
Did you miss the first two articles in this series?
Check them out here:
Or, click here to go to the next article in the series.