wayneL
VIVA LA LIBERTAD, CARAJO!
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- 9 July 2004
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Time decay is known by the greek word "theta" and what everybody knows about theta is that it accelerates in the last month of the options life, losing a substantial whack of its value in the last few days.
In every option text I've ever read, theta is universally depicted by a graph that is something like the following:
This is a graph of the time value of the last 90 days of an ATM option. As you can see, the rate of decay is more or less linear up until the last 30 days, whereupon it starts to decay at an accelerating rate, losing the remaining value very quickly in the last few days.
This is proof that if you short options you should choose options with about a month remaining because that is when most of the decay is.
Or is it?
The above is certainly true for At The Money options. But what about Out of The Money options? What the textbooks don't tell you is that for an option that is somewhat OTM (or somewhat In The Money for that matter) is that the above scenario is not quite true. The characteristics of theta change, the further we go OTM or ITM.
Lets look at a theta graph for an option that is somewhat OTM:
Lo! It seems in this instance, that theta does not accelerate in the final 30 days at all, but rather DECELERATES.
If we are short OTM options we will collect more theta by writing expiry further out... 60 or perhaps 90 days and wind them up before the last month.
This is where "options education" can sometimes be erroneous and it pays to observe, notice things, play around with your strategy modeler and/or excel spreadsheet and really become intimate with these option concepts. It does pay.
In every option text I've ever read, theta is universally depicted by a graph that is something like the following:
This is a graph of the time value of the last 90 days of an ATM option. As you can see, the rate of decay is more or less linear up until the last 30 days, whereupon it starts to decay at an accelerating rate, losing the remaining value very quickly in the last few days.
This is proof that if you short options you should choose options with about a month remaining because that is when most of the decay is.
Or is it?
The above is certainly true for At The Money options. But what about Out of The Money options? What the textbooks don't tell you is that for an option that is somewhat OTM (or somewhat In The Money for that matter) is that the above scenario is not quite true. The characteristics of theta change, the further we go OTM or ITM.
Lets look at a theta graph for an option that is somewhat OTM:
Lo! It seems in this instance, that theta does not accelerate in the final 30 days at all, but rather DECELERATES.
If we are short OTM options we will collect more theta by writing expiry further out... 60 or perhaps 90 days and wind them up before the last month.
This is where "options education" can sometimes be erroneous and it pays to observe, notice things, play around with your strategy modeler and/or excel spreadsheet and really become intimate with these option concepts. It does pay.
