The time-out of the options will vary over time. A bit like me in the bedroom, it starts slowly and then gets very serious just before the end.
There are some things in life that are constant, time is one of them.
Although not all times are the same in the world of options.
This article explains a time decay of options and examines the relationship between theta and gamma.
Theta refers to the decrease in an option price over time. Options have both intrinsic and extrinsic value.
The intrinsic value of the option is the value the option would have if it were exercised today.
The extrinsic value is the price of the option minus the intrinsic value.
This is our time component.
It is easy for beginners to think of theta as constant.
This is wrong.
As long as an option has an extrinsic value, a time decay does occur.
However, the rate of this time decay varies dramatically, as shown in the graph below.
In this table we have the values for three options with one month to expire.
The blue line represents an ATM option, the red line an OTM option and the green line another OTM option.
We notice a couple of things.
Starting with the blue line.
The theta decay continues to accelerate until the day of the expiration. If the option is still an ATM, the theta is greatest (red circle).
Conversely, we notice the green line for the distance OTM option has the opposite shape. It is also sloped downwards, but the slope flattens out over time.
The theta decay is highest initially and then steadily decreases as the option loses value. With the black arrow, the theta decay is minimal.
The reason for this is that the option has already lost almost all of its value and is trading for pennies.
The theta decay is highest for options ATMs just before expiration and highest for options OTM options furthest from expiration.
When we are Put options We’re initially drawn to the shorter ATM options. these have the highest theta decay.
Time lapse isn’t a free lunch, however.
The theta decay is what we collect when the stock is not moving. gamma is what we pay for when it does.
This graph shows the changing gamma for an option over time.
We notice from the red arrow that we have the most gamma.
These are the short term ATM options. On the green circles we have the lowest gamma for the short-term remote OTM options.
If it sounds familiar, it’s the same as our time decay graph. Wherever theta and time decay are highest, gamma is also highest.
Use the graph above and a stock trade at 190. A 205 call option that expires in five days isn’t going to be of much value. Maybe it’s worth 5 cents.
Theta has to be low as the option is only worth 5 cents and can no longer lose.
gamma is also small because it makes almost no difference whether the stock moves from 190-191.
The option is still as good as worthless.
Conversely, the 205 call will expire in 45 days.
It still has some value and therefore will experience theta decay while also having some exposure to gamma.
After all, there’s still a chance the stock could move from 190 to 205 in 45 days. It is very unlikely to happen in just five days.
Imagine it’s NFL Sunday and the over / under for the game between the Chiefs and Bucs is set at 50.
That means there are two options. Bet on the over if we believe more than 50 points will be scored (gamma) or bet on the under (theta).
We bet that.
The game begins.
As soon as the game starts we notice that we are collecting money and the live odds are slowly moving in our favor.
The new over-under is 48.
Nothing has happened yet.
This is our Theta collection in action.
When the time runs out, it’s us Collect thetaalbeit slowly.
The teams stab a few times, but suddenly, touchdown!
The new over-under is 52 and we’re losing money.
This is our negative gamma working against us.
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Now imagine the game progresses and it’s a slumber party.
We’re late in the fourth quarter and the score is 10-3.
At this point it doesn’t matter if a touchdown is scored as there simply isn’t enough time to score 50 points.
Our gamma along with our theta is reduced to almost nothing.
We are at the green line and circles in the graphs above.
Let’s look at an alternative scenario.
The score is 25-21 with 30 seconds on the clock.
The ball on the 10 yard line.
Our bet is still full and we are on the edge of our places.
The time lapse is maximum.
Every second is appreciated.
Conversely, gamma and the ability for our winner to turn to a loser is just a pass.
When we sell volatility We are against the movement of the stock and want exposure to theta.
When we buy volatility, we are betting on the movement of the stock and want exposure to gamma.
There is also no free lunch.
Theta and gamma are constantly fighting each other.
One man’s theta is another man’s gamma.
If you’ve read a little about it Put options It would be tempting to sell these shorter maturity options in order to maximize your theta decay.
However, doing this will also maximize your gamma exposure.
Essentially you are Betting on the outcome of the game in the last game.
The theta decay does not correspond to the variance risk premiums.
It is true, however, that selling options and long-term theta have a slightly positive expectation in the long run.
There is no systematic strategy for taking advantage of this that is better than another.
Ultimately, the options with a shorter term have a higher variance risk premium because they are more difficult to hedge, have more gamma and thus more variance.
Longer-term options have less gamma, but also less theta.
Ultimately for systematic strategiesIt comes down to investor preference.
For more active investors who are willing to hedge often and practice more variance, shorter options may be more fruitful.
For an investor who doesn’t have time to look at their portfolio often or rarely hedge, it would be better to roll longer-term options.
If you are unsure or new to options, I recommend paper trading with both an option that expires in a day and an option that expires within a month, and watch their deltas and profitability change. and loss statement change during the day.
If you enjoy watching sports, you can also watch the betting odds fluctuate dramatically in the final minutes of a close game against a blowout.
The time decay, although it ever occurs, is not constant over time.
By understanding how theta affects different options, we can visualize both our potential returns and our risks related to gamma exposures.
Since theta is constantly changing as the price moves, it is of the utmost importance to be aware of these movements as we can have a position that has a lot more theta and gamma than at the beginning.
Understanding these changes can put us in a better position to understand our income statements and ultimately our trades.
Disclaimer: The above information applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.