Time decay is an issue that affects all option traders. Depending on your strategy and the actual positions in play, the concept of time decay is either working against you or to your advantage.
The rate of time decay is a very important concept for option traders because it affects the profitability of different strategies. For the put selling strategy we use over at Income Trader, theta works in our favor. As options sellers, as the value of an option erodes, our portfolio value steadily increases.
To understand how theta affects the market prices for option contracts, it is helpful to look at the two main components of an options price.
Intrinsic vs. Extrinsic Value
The value of every option contract is comprised of two different measurements: intrinsic value and extrinsic value.
Extrinsic value is the difference between an option's market price and its intrinsic value. In other words, it is the remaining portion of the option contract's value, or the additional premium that an option buyer pays for the potential upside should the underlying stock move higher (for call contracts) or lower (for put contracts).
For example, consider a stock that is trading at $47 and a three-month call option with a $45 strike price. Assume the price of this call contract is $4.50. In this instance, the intrinsic value of the contract is $2 (because the option is $2 in the money). The extrinsic value for this contract is the remaining $2.50. This is the speculative value of the option contract, which represents the potential for a stock to trade higher over the next three months.
It's important to note that for call and put contracts that are out of the money, the entire value of the contract is extrinsic. This is because unless the stock price moves to a point where the contract is actually in the money, the contract will expire worthless.
This brings us back to the concept of theta. Time decay only affects the extrinsic portion of a contract's value.
So there are two primary things to consider when determining the rate at which a contract will lose value. First, we need to figure out how much of the value is eligible for time decay, by determining the amount of extrinsic value in the contract. Second, we need to note how much time is left until the options expire.
Timing is Everything
For option contracts with a significant amount of time left before expiration (six months or more), theta is typically very low. This is because one less day of trading before expiration doesn't significantly alter the long-term potential for the intrinsic value of the contract to increase.
However, as an option contract approaches its expiration date, the rate of theta, or time decay, picks up significantly. Ultimately, the extrinsic value is trading down to zero, and the option will only be worth its intrinsic value upon expiration.
This has very important ramifications for our put selling strategy. Since theta increases as we get closer to the expiration date and is an important part of our ultimate profitability, we want to sell put option contracts that have a relatively high theta or rate of time decay.
Typically, I like to sell put contracts that expire in the next four to eight weeks. This gives us enough extrinsic value to make a decent amount of income, while collecting that income in the shortest amount of time.
Of course, the object is to sell puts on stocks that we ultimately want to own at a lower price, but putting the maximum amount of theta in our favor helps to increase profits and generate reliable income during periods when the underlying stocks are stable or moving higher.
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(This article originally appeared on ProfitableTrading.com.)