Trading Strategy to profit from Options Theta Decay
Time Decay ( also known as Theta Decay ) is the only
The chart above shows the Mini S&P futures contract vs. the SPY. The yellow line (known as the spread) decreases due to carrying costs. The CONSISTENT DECLINE in the value of the spread is known as Time Decay.
The chart above shows the Mini Nasdaq futures contract vs. the QQQQ. Again, we can see the CONSISTENT TIME DECAY!!!
Options have limited life spans. As an option nears its expiration date it loses time value. Understanding this loss of time value, allows us to increase the probability of seeing profits in our option trading.
THETA DECAY REFLECTS DIMINISHING TIME VALUE
The theoretical measure of how much time value is being lost is referred to as "theta." When you buy an option, it will have a negative theta because that option is losing time value each and every day.
Conversely, a short option position will have a positive theta. With each passing day that option is losing value to time decay. This loss of value allows you to buy-to-close your short option position at a lower cost.
Theta decay is not linear, however. An option with many months of time value will see very slight erosion due to time decay. As expiration approaches, theta decay begins to accelerate. The most pronounced time decay occurs in the last weeks prior to expiration.
WHY IT WORKS
Expiration is never a surprise. We always know precisely when an option is going to expire. Because expiration and time decay are certainties, a favorite strategy of many option traders is to be a net seller of option premium.
There is a 100% probability of an option losing 100% of its time value. Remember, the value of an option is composed of time value and, if the option is in-the-money, it will also carry intrinsic value. By selling an option and holding the short position to expiration, you will only lose money if that option expires in-the-money.
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