Option Investor
Educational Article

If My Underlying's Prices Aren't Going Anywhere, Why Is My Option Price Headed South?

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Trading-related publications often warn traders that they need to plan their exits before entering a trade. Traders need to know where their stops are going if prices move against their trade and where they'll take profit if prices move with the trade.

Options traders need to know more. They need to know what to do if the underlying goes sideways. While the underlying goes sideways, their options prices are likely going south.

For example, imagine that with imaginary company BRBL at 19.00 thirty days before expiration, you buy a call at the 19 strike, priced at $0.99. Seven days pass. Nothing has happened, and BRBL is still sitting at $19.00. Imagine that implied volatility is neither higher nor lower, and interest rates haven't changed. None of the other parameters that go into an options price have changed.

Oh, but the price would have changed. According to an option pricer, with twenty-three days left until expiration, that 19 strike call would be worth only $0.87.

The difference would be more striking as expiration neared. Imagine that ten days before option expiration, imaginary company BRBL's price is still at 19.00, but all other inputs into option price remain the same. That 19 strike call's price has dropped to $0.56. Let another week pass, the same period of time that produced a $0.12 decrease in price before, and the 19 strike call's price has fallen to $0.30. It's decreased $0.26 this time, a much steeper decline than in the one-week period studied in the first example.

This illustrates one property of theta, an aspect of option pricing that some call time decay. Theta-related decay accelerates as option expiration approaches. If price is graphed against time, the decay is not a straight line but rather a curve that drops sharply as expiration nears.

Theta is expressed as a negative number that tells how much an option's price loses as each day passes. An option with a theta of -1.03 will theoretically lose $1.03 in value for each day that passes. Your position will lose that value times the multiplier, 100 for most options contracts. That means that if you have one contract with a theta of -1.03, your position loses $103 each day.

A volatile stock's options are more expensive than a less volatile stock's options, and also tend to have thetas with larger absolute values. There's more extrinsic value in those expensive options to ebb away before expiration.

Of course other things can happen to change an option's price, either offsetting or accentuating the theta-related decay. For example, price or volatility might change. Both inputs change an option's price.

However, it's important to remember that if you've bought that option, theta-related decay is your enemy. If you've sold it to someone else, theta is your friend. That someone else is holding the decaying asset.

Theta reminds us that options are a wasting asset. If a stock is bought at $50.00, drops to $45.00, and then scrambles back to $50.00 ten days later, the stock is still worth exactly $50.00. However, if a $50 strike call is bought when the stock is $50, then held while the stock drops to $45 and then scrambles back up to $50 again ten days later, the call is likely to be worth much less than it was when it was purchased ten days previously. A former writer for the site once said that theta-related decay is the price that options traders pay for being able to trade both directions, using either calls or puts. That's a one-sided view, however, since theta-related decay could also be called the option-sellers gift.

Whether buying or selling options, option traders need to acquaint themselves with the effect of theta-related decay. Option traders must anticipate a big move in a short time if they're buying options close to expiration, when theta-related decay accelerates. Someone anticipating a decline that will unfold over two to three weeks probably would not want to buy a put that will expire in 25 days, but a trader who was scalping a few points one morning with intentions to be out of the trade by noon might be willing to do so. Option sellers want to sell options close enough to expiration to benefit from accelerated decay.

New option traders who would like to develop a sense of how option pricing changes as theta-related decay kicks in can go to iVolatility.com where they'll find a "Basic Calculator" on the left-hand sidebar. That calculator allows traders to experiment with various inputs, including the number of days until expiration. Keeping all other inputs the same, traders can shorten or length time until expiration and determine how an option's price will change. Experimentation should simulate both sedate stocks, with low volatilities, and volatile ones, with higher volatilities. For example, as this article was prepared, ROH's current-month near-the-money call had an implied volatility of 18.93, while GOOG's had an implied volatility of 72.98. Test the difference in a one-week passage of time far from expiration and one much nearer expiration for sedate and volatile underlyings.

Some brokerage pages also provide this testing capability. These days, many do more. They provide a profit/loss chart that allows traders to input new conditions, including a passage of time. For example, if a trader had purchased 4 CI DEC 2008 Puts (.CIXC) at market on 11/10/2008, the following P/L chart shows how time decay works against the option buyer.

BrokersXpress P/L Chart for .CIXC on 11/28 and 12/19/2008:
[Image 1]

With all other inputs into option pricing kept steady, this P/L chart suggested that the 4-contract position originally entered at market price would have been profitable as long as CI's price stayed below $13.61 on November 28, 2008, but by option expiration in December, theta-related decay had wiped out all possibility of profit unless CI stayed below $12.40. Moreover, a full loss was reached quicker by option expiration, while the losses would have accrued more slowly if CI had moved up on November 28.

Working with iVolatility's tables and P/L charts such as these can help traders obtain a working knowledge of how theta-related decay impacts their trades. A trader who was considering a combination trade such as a condor, butterfly or calendar that would benefit from theta-related decay would also be able to see how that impact played out over time on such charts. Traders who experiment with broker-based P/L charts should be aware that traders experimenting with the same trade on several trading platforms have reported that not all platforms report the same numbers. Use such charts to obtain a feel for how the theta-related decay impacts trades without counting on them to play out exactly as depicted. When possible, calculate break-even amounts manually rather than relying on the chart alone.

While not counting on such charts to play out exactly as depicted, traders who experiment in this way will soon have an understanding of how theta-related decay will impact their positions.

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