As expiration nears, how does theta behave?

Mark,

I am currently on my second round reviewing the greeks, and this time I am going into more depth. As I am putting together my notes I found references that describe time decay for both OTM and ATM positions. To my surprise, the shape of the graphs is different.

The graph that we are all accustomed to seeing shows that time decay accelerates as expiration nears. Most of the theta decay occurs in the last 30 days in which theta is increasing as the remaining time value of the option is decreasing.

Time_value_of_an_option__standard

When it comes to OTM options, according to the authors, the shape changes significantly. In the last 30 days, decay decelerates and the majority of the decay occurs before the last 30 days. This is the graph of an OTM option and its time decay.

Time_value_OTM_options_

I have been looking at various option series for both stocks and ETFs and I have not been able to confirm this.

Question.

If the above statement is true, when trading iron condors, why wouldn't you pick a timeframe for opening the position near 60 days to expiration and probably closing ~30 days before expiration? This would allow the trader to capture a larger portion of the time decay – because OTM positions make up the iron condor.

JG

***

This is a very thoughtful question and illustrates why spending time trying to understand the things we are taught is such a good idea.  Thank you.

The general view regarding time decay is correct.  Theta accelerates as expiration approaches.  However, we must recognize that some siturations are different.  Let's say that a stock is trading near 79, there's a week left prior to expiration, and the option under consideration is the 80 call.  Surely that option has time value and with that comes time decay – and the option loses value every day.  Just as you anticipate.

However, consider the call option with a 50 strike.  Unless this stock trades with an extreme volatility, the call has already lost all time value (except for a component due to interest rates) and trades with a bid that is below parity. 

Or you can look at the corresponding put (which has the same theta) and see that it doesn't trade and the bid is zero. It has already lost every penny of it's time value.  Its theta is zero.

These are the situations to which your references are referring when stating that time decay decellerates into expiration.  When options move to zero delta and 100 delta, the time decays disappears prior to expiration.

Most traders who are talking about options and their time decay, are not interested in such options (there is nothing of interest for a trader to discuss).  Thus, options such s the 80 call mentioned above (and the corresponding 80 put) have time value, accelerating time decay and an increasing positive gamma.  These options decay according to your first, or 'standard' graph.

FOTM options

There is more to the rate of time decay than the time remaining.  When options are far OTM or deep ITM, things are just different.  Once you understand that situation (as I'm certain you do now), the theta problem goes away. Once an option has only a small time premium remaining, it cannot keep losing value at the same rate – or else it would become worth less than zero.

Iron Condors

Time decay is what makes trading iron condors profitable. Sure it may be good to own the position when time decay is most rapid, but that is not the 60 to 30-day iron condors that you envision.  That would work only when the calls and puts are both quite far OTM.  That means a tiny premium to start the trade.  That's a non-starter for me.

In the real world of condor trading, most options are not that far OTM and have enough time premium to belong in the standard decay group.  When markets behave for premium sellers, the last 30 days are the periods with the most rapid time decay.  For most iron condor traders, that is the ideal situation. However, that's also the period of highest risk – due to negative gamma.  For me, collecting the fastest time decay is not as important as owning a less risky trade.

863

Liberty

Peace on Earth.  Liberty for all.  Best wishes for 2011

 

 

, , , , , ,

2 Responses to As expiration nears, how does theta behave?

  1. Keiser 12/29/2010 at 11:09 AM #

    I read in your blogs that your prefered underlying IC instrument is RUT. How often do you get good execution prices with RUT spreads? It’s hard for me to get the “mid-price”. Do you have any suggestions on execution prices?

  2. Mark Wolfinger 12/29/2010 at 12:02 PM #

    Hi Keiser,
    This is a good topic for a separate post. I’ll use it Friday.
    Short answer: I don’t know how good the executions are. This is primarily due to the fact that I trade options that are not very liquid. They are low volume options, and I have no comparative data.
    Thanks. Good questions.