#659 - Theta Of An Option Contract

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Manage episode 237945375 series 1615906
By Kirk Du Plessis. Discovered by Player FM and our community — copyright is owned by the publisher, not Player FM, and audio is streamed directly from their servers. Hit the Subscribe button to track updates in Player FM, or paste the feed URL into other podcast apps.

Hey everyone. This is Kirk here again from Option Alpha and welcome back to the daily call. Today, we’re going to be talking about Theta of an option contract. The Theta of an option contract is a critically important concept for you to understand, especially if you’re a new options trader, but even if you’re an experienced options trader, hopefully you get a lot out of this. Theta is basically the Greek representation for time decay. I always think T from Theta as related to T for the time decay of the option contract. Now, as opposed to many of the other Greeks in option pricing formulas and inputs that go into it, Theta is really the one thing that is the continual constant and that’s because time marches on. It never slows down, stops or speeds up. Every day passes at the same interval and the same frequency as the day before. Theta is a really good conceptual understanding of how time passes in the option contract and how the passage of time can erode the value of an option contract faster and faster. We know that option contracts that are far out in time have very little Theta decay and that’s because the contract that’s say six months out in time has a long time before that option contract is going to reach expiration. As we’re getting closer and closer to expiration, six months seems pretty far out, so that every day that we get closer to six months expiration is not really that big of a deal. But something that’s say seven days from expiration, well, every day is really getting closer. Now, we’re starting to increase the speed exponentially as we get closer to expiration. Contracts with seven days as opposed to contracts with 60 days have more time decay. They start to lose their value faster and faster and faster.

The way that I was always explained this concept and I think probably the best example of this was many, many years ago, has explained Theta as drops in a bucket. An option contract is basically this bucket of water that you fill up and the bucket of water has been poured into this bucket and then someone drills a tiny little hole in the bottom of the bucket and that’s Theta decay, that’s time. Now, when the bucket is full of water, that tiny little hole that’s dripping water every single day at a similar and constant pace doesn’t seem like a lot because you have a lot of water in the bucket. This is representing option contracts with a lot of time value left in them, option contracts that are really far out in expiration, three months, six months, a year, two years out in expiration. At that point, the small drop of water that’s coming out of the bottom of the bucket doesn’t seem like a lot. It’s not a high percentage of the total value of that bucket of water. But as you get closer and closer to running out of water, as expiration nears and the value of the contract starts to drop because we’re getting closer to expiration, well, now, every single day, that drop of water that’s coming out of it or those drips of water start to represent a higher and higher amount or percentage of the total water that’s left in the bucket. We start to lose value. And that’s really what time decay is. Time decay is this increasing curve that starts to accelerate as we get closer to expiration. It’s a slow drip of water that starts to remove value from the contract for further out contracts. But as you get closer to expiration, the drops of water still maintain their pace. They just end up becoming a larger and larger portion of what’s left in the contract.

This is really important to understand as an options trader because as an option buyer, Theta decay is working against you. It is eroding the value of your contract so much so that you really need the stock to make a move and make a move quickly before Theta decay rips all the value out of it. As an option seller, Theta works to our advantage, but sometimes, it feels like we’re not really making any progress because as an option seller, we sold this option contract and we’re looking for all the water to be sucked out of this bucket, but in some cases, it might happen just a couple of drips at a time. And so, this is really good because as an option seller in particular, we can conceptually think about this as the bucket of water with drips and just understand that Theta decay will occur. It will happen, but it’s probably going to take some time. You probably have to be patient to let all the water kind of get sucked out of that small little hole at the bottom of the bucket and that may take 30 days, it may take 60 days of patience to let that maturity happen, but it’s really, really worth it. Hopefully this helps out. Hopefully it was a good concept. If you did like it or if you didn’t like it, let us know. Just give us your feedback online or on social media. Post a review for the podcast. We’d always love that. That’s how we spread the word here at Option Alpha and until next time, happy trading.

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