I know I have been writing about options a lot lately, but currently that is the shiny object that has all my attention when it comes to investing and creating wealth. When I sell a naked put I collect a premium to take the risk that someone can put to me 100 shares of a particular stock if it goes below the predefined strike price by a certain expiration. Time decay (also known as Theta) is an option seller’s friend, and let’s take a look why.
Breaking Down a Put Sale Example
I always find an example is the best way to explain options
- Stock is worth $50
- Sell a put contract that says in 1 month you can put to me 100 shares (1 options contract = 100 shares) at a $40 Strike price
- To take on that obligation you paid me $30 (.30 * 100 shares)
Time decay, or theta, is enemy number one for the option buyer. On the other hand, it’s usually the option seller’s best friend. Theta is the amount the price of calls and puts will decrease (at least in theory) for a one-day change in the time to expiration.***In the options market, the passage of time is similar to the effect of the hot summer sun on a block of ice. Each moment that passes causes some of the option’s time value to “melt away.” Furthermore, not only does the time value melt away, it does so at an accelerated rate as expiration approaches.
Using my example, if the stock is at $48 with 3 weeks to go then the put contract is worth $X, but if that same stock is at $48 with 3 days to go, all things being equal, has to be working $X – $Y.
The effects of time decay intensifies you get closer to the expiration date of the contract. If you take a 30,000 foot view it makes a lot of sense – is something that hasn’t happen yet more or less likely to occur with less time? Those close you get to zero days the less likely that a stock may drop 2%, 5%, 10% or 20%. Is the chance, 0%? Depending on the stock it may be pretty damn close. What are the odds that in 1 day a company like MSFT is going to lose 10% of its market cap? Pretty close to zero. Alternatively, a company like Tesla, may move 5 to 10% overnight so there will still be extrinsic value in the contract.
Time decay is measured/calculated as Theta:
However, I have zero clue how it is calculated, nor do I have any desire to learn what those variables even mean! I just need to depend on the idea that as time goes on the put I sold is likely to decrease in value so when I buy it back I will profit.