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What is Theta decay – Why do options rapidly decay in price the closer we get to options expiration?

Time decay in options is called ‘Theta’ decay. That is purely due to the appetite of options traders to use Greek terminology wherever and whenever possible. Theta decay and Time decay mean the same thing and are a measure of how the passage of time influences the price of an option.

Exercise

Any option that you are studying the price of will have that price determined by a range of factors which are all likely to be influencing the price at the same time. Taking a hypothetical situation where all other variables are constant illustrates the role of time on option prices and some of the ‘quirks’ that come about when considering Theta.

Holding an option contract gives you the ability (but not the obligation) to ‘exercise’ the option for the underlier. If for example, the underlier of the option is equity then the holder can exercise the option and will have their holding converted from options to the equivalent equity.

Expiration

If you are holding what are known ‘European Options’, then you can only exercise (from option to underlier) on Expiration date. ‘US Options’ on the other hand have slightly different T&Cs and you can exercise those at any time prior to, and including, the Expiration date. In either case you are holding a ‘wasting’ asset as the contract only applies up to the previously agreed deadline.

Price of the ‘same’ Option with different Expiry dates
Below is the price chart for UK Large Cap retailer Marks and Spencer. The current price of this CFD is 308.20

Options relating to the MKS LN CFD underlier with Expiry date 21stDec 2018 are priced as below:

Call Options with Strike Price 340 but Expiry date 1 month later (18th Jan 2019) cost more to buy 6.25

Longer dated Call options with the same Strike price but Expiry date of June 2019 cost 12.75 to buy.

Interactive Brokers Paper Demo account: Options Monitor for MKS CFD 20181126

The MKS LN CFD Call Option being analyzed has the same characteristics apart from Expiration date, and Theta decay is what explains why longer dated options have higher prices. Put another way, if you buy the MKS LN CFD Call 340 with the underlier trading at 308 then you have only 25 days for the December option to come into the money but over six months for the June option to do so.

MKS LN is a perennial subject of takeover rumor and gossip and the June option gives you six months exposure to news events. Remember, even unfounded rumors cause prices to spike.

Rate of decay

Theta decay tends to accelerate as options get closer to Expiry date. The daily rate of change would be less for an option that is 11 months from expiry than one that is only days away. That is because historical daily price volatility forms part of the calculation of option prices. Using historical closing price data it becomes clear what probability can be applied to what degree of a daily price move.

Of course, Historical Volatility is a methodology that studies past prices rather than predicts future ones; however, if you’re holding an option that is a long way out of the money and there are only a few days until expiry and its historical probability shows it has low daily price volatility there is a greater need for each daily movement to be in the right direction. This requirement for a combination of successive events to be in your favor is what causes Theta decay to accelerate. A six months until expiry price can move towards being in the money, fall away, move again and take a fairly circuitous route to finally being profitable.