Time Decay, the Greeks and Options Trading

The clich� says none of us can avoid death and taxes. For option traders there are two things that are certain: Death and theta. The smart option trader must use theta wisely to be a success.

Time Decay

Theta is a measure of the rate of decline in the value of an option due to the passage of time, according to Investopedia. As the amount of time until expiration decreases, so does the value of the option, assuming all other pricing factors are held constant. This is intuitive when one considers that options with less time until expiration have less practical use to a trader. Therefore, as each day passes, the option has less use, and consequently less value.

While this is a detriment to option buyers, it is a bona fide benefit to option sellers. Though the short option player retains the risk of volatility (in terms of gamma and vega) time always helps.

Theta Optimization

All thetas were not created equal. First, shorter-term at-the-money (ATM) options have higher option thetas than their longer-term counterparts. Traders looking to squeeze the most juice out of their options find it in these shorter-term plays.

Next, ATM options have a higher theta than in-the-money (ITM) options or out-of-the-money (OTM) options. At-the-moneys are meatier in terms of time value, but that also means they must lose value at a faster rate.

Word to the Wise

While it seems obvious to sell the shortest-term ATM option to eke out the most theta, the risks can increase with these options as well. Short-term ATMs also have the highest gamma. That means stock volatility has more of an adverse effect on these options than their alternatives. Plus, selling ATMs provides less of a buffer than out-of-the-money options.

This article originally appeared on Traders Reserve.

For more information contact dan@markettaker.com or visit http://markettaker.com.

Author and options educator Dan Passarelli is the founder of Market Taker Mentoring LLC. Dan has more than 17 years’ experience in the options industry and has worked as both a floor trader and an options instructor.