Time decay (theta)

Time value decay

Part of the value of an option derives from how much time remains until it expires. The more time remaining, the greater the possibility of large stock price movements that could make the option much more (or less) valuable. Options lose "time value" very rapidly as they approach expiration.

Options Laboratory calculates and graphs this "theta" parameter in share-weighted, dollar terms. If you read a point on the graph as showing a time decay of -10.50 at a share price of $45, that means the position will lose $10.50 a day when the share price is $45 (because the time decay is negative in this case).

Normally you will want to see time decay plotted with the projection date slider at its leftmost position, to show how fast you're losing value "right now"..

Here's the time decay graph for a covered-call position consisting of 300 shares, and 3 calls that will expire in 3 days. The stock is at $72.30 and the call strike price is 75. Since it's a covered call, the options are "short" - they were written against the stock.

You can see that the decay is about +48 per day. If the stock price doesn't change, you will gain about $48 a day until the option expires, because these calls are out-of-the-money. Unless the stock rises above 75, you will get to keep both the stock and the premium you received for selling the calls. This is a good picture.

How to use this information

If you're killing time while the stock price isn't moving as you'd hoped, an option's value is steadily melting away. You're losing money if you are long the option; gaining if you wrote the option. This is quantified in the time decay graph.

Certain strategies actually depend on the differential rate of time decay between options with significantly different expiration dates. A "calendar spread" involves buying a call with a long remaining life, and selling a similar call that expires very soon. For example, in January when a stock is at 100, you might buy an October 100 call and simultaneously sell a February 100 call. This is like writing a "covered call" against shares you own, except that the October 100 call stands in for the shares.

This strategy owes any potential profit to two factors. First, you should try to pay a little less than fair value for the call you buy, and sell the call you write for a little more than fair value. Second, the short call - being near expiration - will lose value much faster than the long one. In the best instance it will expire worthless while the long call still retains considerable time value. Calendar spreads are often set up using LEAPS™, which are option contracts with terms of a year or more.

When evaluating any combination of options with different expiration dates, the time decay graph reveals whether the decays offset or complement your intended strategy.