And<\/p>\n
2) How Implied Volatility Works<\/a><\/strong><\/span><\/p>\n Now, we\u2019re going to explore another critical factor in options pricing: time<\/p>\n You're about to learn:<\/p>\n This article is somewhat technical in nature.<\/p>\n You don\u2019t need to understand all the math.<\/p>\n You certainly don\u2019t need to know this formula:<\/p>\n So just focus on learning the basic principles, and you'll be a step ahead of options traders that fail to grasp the role of time in options.<\/p>\n In our recent article on implied volatility<\/a><\/strong><\/span>, we identified the 7 basic factors that determine an option\u2019s price:<\/p>\n While implied volatility is the most important factor in an option\u2019s price, time is a close second.<\/p>\n Remember what we said about options — they\u2019re a form of insurance.<\/p>\n A call option is an insurance contract that pays off when the stock rises.<\/p>\n And a put option is an insurance contract that pays off when the stock falls.<\/p>\n And like a car, the faster a stock moves, the higher it costs to insure it with options.<\/p>\n But what else affects the price of insurance?<\/p>\n Time.<\/p>\n Would it cost more to insure your car for 1 year?<\/p>\n Or 2 years?<\/p>\n Obviously, you pay more for 2 years of insurance coverage than 1.<\/p>\n Why?<\/p>\n Because over a 2-year period, there\u2019s a much greater chance of something happening than over 1 year.<\/p>\n And so it goes with options: the longer the time to expiration, the higher the price of the option (insurance).<\/p>\n Let\u2019s take a look at Facebook<\/strong> (FB) $175 call options across a wide range of expirations. As of the time of publication, the stock was trading at $176.46.<\/p>\n Here are the prices for all FB $175 call options that are currently trading. They have expirations ranging from 2 to 793 days from today:<\/p>\n As you can see, the $175 call option expiring in 2 days is priced at just $2.<\/p>\n The option expiring in 93 days costs $9.61.<\/p>\n And the call option expiring in 793 days costs $32.10!<\/p>\n Why?<\/p>\n Because again, options are a form of insurance. And it\u2019s only logical 793 days of coverage costs more than 2 days of coverage.<\/p>\n Remember what I just said about our Facebook example.<\/p>\n 793 days of coverage costs more than 2 days of coverage.<\/p>\n And you know what?<\/p>\n 793 days of coverage also costs more than 791 days of coverage\u2026 and 790 days of coverage, and 789 days of coverage\u2026 and so on.<\/p>\n So all things being equal, options lose value as time passes.<\/p>\n And theta is a measure of how fast that loss of value happens.<\/p>\n No.<\/p>\n Theta is simply a reality of the world of options trading.<\/p>\n And it's a concept you have to understand if you want to make money with options.<\/p>\n Plus, there are strategies that actually take advantage of theta, though they are beyond the scope of this article.<\/p>\n At publication, the Facebook $175 call option expiring in 9 days is currently priced at $3.18.<\/p>\n The stock is trading at $176.46.<\/p>\n This means there is a premium of $1.72 built into the option.<\/p>\n This is calculated as the strike price + the options price – current stock price, or $175 + $3.18 – $176.46 = $1.72.<\/p>\n The amount of premium built into the option is affected by implied volatility and other factors.<\/p>\n The higher the implied volatility, the higher the premium.<\/p>\n Theta, or time decay, is the dollar amount by which this premium declines each day.<\/p>\n You can find the theta of an option on virtually any trading platform.<\/p>\n Theta is displayed as a negative number, typically without a dollar sign.<\/p>\n So if you see a theta of -0.10, that means the option will decline by $0.10 per day, all things being equal.<\/p>\n (we use dollar signs in this article to reinforce the fact that it is indeed a dollar amount)<\/p>\n The theta for our Facebook $175 call expiring in 9 days is -$0.12.<\/p>\n This means that if Facebook\u2019s stock doesn\u2019t move at all, it will be worth $0.12 less tomorrow, or $3.06.<\/p>\n And that\u2019s why time is an option\u2019s kryptonite.<\/p>\n If the underlying stock or ETF doesn\u2019t move, the passage of time will reduce the value of your option.<\/p>\n Theta continually changes.<\/p>\n And the closer an option is to expiration, the faster it loses value.<\/p>\n Here is the theta for our Facebook $175 call options by each expiration:<\/p>\n As you can see, the option expiring in 2 days has a theta of -$0.16.<\/p>\n And the one expiring in 793 days has a theta of just -$0.02.<\/p>\n This is a simple illustration of one of the most important concepts in options: the closer an option gets to expiration, the bigger the theta is.<\/p>\n Why?<\/p>\n Think of of it this way: if an option expires in 9 days, each day accounts for 11.1% of the time left to expiration.<\/p>\n And if an option is expiring in 793 days, each accounts for just 0.13% of the time left to expiration. So it's not going to change much.<\/p>\n Now, let\u2019s look at the theta table one more time, because there is an exception to the rule that the closer an options gets to expiration, the bigger the theta is.<\/p>\n As you can see, the option expiring in 16 days has a theta of -$0.15, which is bigger than the -$0.12 theta of the option expiring in 9 days.<\/p>\n This is because Facebook will report earnings in between days 9 and 16, so the options expiring on Day 16 have a high implied volatility.<\/p>\n The higher the implied volatility, the higher the theta.<\/p>\n That means more premium that gets\u00a0eaten away by theta.<\/p>\n At-the-money options have the highest theta, and thus the highest amount of money to lose through time.<\/p>\n Options that are in the money have a lower theta because they are largely comprised of intrinsic value, rather than premium.<\/p>\n And out of the money options have a lower theta because they have so much less premium to lose in the first place.<\/p>\n There are some exceptions to these rules, particularly with extremely far in and out-of-the-money options, but you should rarely if ever be trading those options anyway.<\/p>\n Here is an example using Apple<\/strong> (AAPL) options expiring in 30 days. At publication, Apple was trading at $160 on the dot, putting the $160 call perfectly at-the money.<\/p>\n As you can see, the $160 call has theta of -$0.07, making it the highest in our example.<\/p>\n We know that as time goes on, all things being equal, options lose value due to the passage of time<\/p>\n And as time goes on, the rate at which options lose value accelerates.<\/p>\n So when we buy an option, we\u2019re speculating that the option will rise in value at a rate that offsets time decay.<\/p>\n Let\u2019s take an example using the iShares Russell 2000 ETF<\/strong> (IWM).<\/p>\n At the time of publication, IWM was trading at $149.87.<\/p>\n The December $150 call expiring in 58 days is currently trading at $3.11, and has implied volatility of 13.3%.<\/p>\n We\u2019re going to assume that everything stays the same, except the number of days to expiration.<\/p>\n According to the CBOE\u2019s options calculator<\/a><\/strong><\/span>, if 28 days pass and the ETF is still at $149.87, the options price would be just $2.29.<\/p>\n That\u2019s a loss of 72 cents, or 36%.<\/p>\n And if IWM was still at $149.87 with 10 days to expiration, the $150 call would be worth just $1.28<\/p>\n That\u2019s a loss of $1.83, or 59%.<\/p>\n Assume IWM rose to $152 with 10 days to expiration.<\/p>\n The option would only be worth $2.60 for a loss of 51 cents, or 16%.<\/p>\n Why?<\/p>\n Because the stock didn't move enough to offset the impact of theta.<\/p>\n Throughout this article, we\u2019ve discussed how the passage of time eats away at the value of options.<\/p>\n But remember what we said in our introduction to options article<\/a><\/strong><\/span>: options are a zero sum game.<\/p>\n When someone is winning, someone else is losing on the other side of a trade.<\/p>\n Since time decay pushes down the value of options and punishes options buyers, it benefits options sellers.<\/p>\n So if we bought IWM calls and lost 16% because of time decay, someone would be gaining 16% — the seller of the option.<\/p>\n They're short, so they're profiting from the drop in the option's value.<\/p>\n Shorting options is incredibly risky, and we don\u2019t recommend shorting options \u201cnaked.\u201d (naked shorting means shorting a call or put option without an offsetting position to limit the risk of the trade)<\/p>\n However, we want you to understand the mechanics of the market, which is why we're explaining it.<\/p>\n Again, you don\u2019t need to understand the nitty gritty of the mathematics to successfully trade options.<\/p>\n But you must understand the three basics options principles illustrated in this article:<\/p>\n Sadly enough, most options traders don't understand these concepts.<\/p>\n So by learning them, you're getting a step ahead of the crowd!<\/p>\n Did you miss the first two articles in this series?<\/p>\n Check them out here:<\/p>\n 1) The ABC\u2019s of Puts and Calls<\/a><\/strong><\/span><\/p>\n 2) How Implied Volatility Works<\/a><\/strong><\/span><\/p>\n\n
![\"\"](\"http:\/\/www.t3live.com\/blog\/wp-content\/uploads\/2017\/10\/theta-options-formula2.png\")
<\/p>\nThe Basics of Time's Effect on Options Prices<\/h3>\n
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A Time Example with Facebook Options<\/h3>\n
![\"\"](\"http:\/\/www.t3live.com\/blog\/wp-content\/uploads\/2017\/10\/FB-options-theta-days-time-decay.png\")
<\/p>\nTheta Is Kryptonite to an Option<\/h3>\n
Is Inherently Bad?<\/h3>\n
An Example of Theta, and How It Eats an Option\u2019s Price<\/h3>\n
How Theta Varies Over Time<\/h3>\n
![\"\"](\"http:\/\/www.t3live.com\/blog\/wp-content\/uploads\/2017\/10\/FB-options-theta-days-time-days.png\")
<\/p>\n<\/p>\nTheta with In-the-Money, At-the-Money, and Out-of-the-Money Options<\/h3>\n
![\"\"](\"http:\/\/www.t3live.com\/blog\/wp-content\/uploads\/2017\/10\/theta-options-aapl.png\")
<\/p>\nHow Time Decay Can Cost You Money<\/h3>\n
How to Buy a Call Options, Have the Stock Go Up, and Still Lose Money<\/h3>\n
Short Options vs. Long Options<\/strong><\/h3>\n
Final Words on Theta<\/h3>\n
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