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Hey everyone, Kirk here again and welcome back to the daily call. On today’s call, we are going to answer the question – “What is Theta decay in options trading and more importantly, how does it work or what do you need to be aware of?” Put very simply, Theta decay is one of the Greeks that’s involved in option pricing. Now, it doesn't tell you what an options price is, but rather, tells you what the options price could do over time as different factors change. Theta specifically refers to the time decay aspect of an option contract. I always think about it as E for Theta and T for time decay. That’s just a very simple way to associate them together. The time decay aspect or Theta decay of an options contract basically means that as options contracts near expiration, near their expiration date, they start to lose value at a faster and faster pace. It’s because the option contracts are wasting assets, meaning they have a finite life. They expire or end their life cycle at different expiration dates in the future, whether it's a year out, two years out, whether it’s 10 days out or 30 days out. As they get closer and closer and closer to their expiration date, the value starts to erode because they’re running out of time. They’re running out of time to be profitable or not, to make a bid for the stock, to make a big move higher or not or whatever the case is. Now, Theta decay, if you graph it… You can search online. We’ve got graphs on Option Alpha, so you can just search Theta decay or time decay on our website and you can find these graphs. But Theta decay, if you graph it on an X and Y axis starts off very flat. The further you are out in time from expiration, the flatter or the minimal impact you'll see in the options contract because of Theta decay or time decay. If your option contract is say 100 days out from expiration, you may only lose a dollar or less every single day to time decay. Now, those option contracts are also going to be worth a lot of money because they’ve got a lot of time. They’ve got a lot of time for the stock to move. It’s got 100 days to move. As you get closer to expiration, that Theta decay starts to speed up and it speeds up at an exponential pace, meaning the closer and closer you get to expiration, it starts to speed up until you’re starting to basically lose a significant portion of the option contract every single day just purely because of the Theta decay. What I think about when I think about decay, I truly think about like wood rotting. Say you have this bucket and this bucket is filled with water and this bucket then has a slow drip in the bottom of the bucket. Well, over time, that slow drip starts to erode the wood away and now you have a bigger drip and then it’s starting to gush water until the point at which it just absolutely opens up the flood gates and all the water comes rushing out. That's the way that I think about Theta decay with options trading. I think about this slow drip that seemingly doesn't have any impact, but then over time, it starts to really erode away the value of the contract faster and faster. Now, when we just use some simple pricing here just to prove this point… I’m looking at the SPY right now which is a major market ETF. The SPY options for January of next year… The time I’m recording this, those options are about 74 days out from expiration. Those options have a Theta decay of just $1. Now, they’re worth $446 and these are the at the money contracts, but they have a Theta decay of just $1. Every day, no matter what happens, they’re going to lose just purely because of time decay a dollar. Now, they can make up that dollar by increasing or by the stock increasing its price and going up or the stock going down in price. It doesn’t matter. Theta decay impacts both sides of options contracts basically the same, meaning the Theta decay is a constant erosion of value whether you are long calls or long puts. As an option seller, this is premium that you get. This is a benefit to you because you want the value to go down. Again, these contracts that are out on SPY 74 days have a Theta decay of just $1. Now, if we go in substantially to 39 days, so 39 days away, the Theta decay has now increased to $3 a day. Now, the value of the contracts also come down to $3.31, so $331, but now the decay is starting to become more of a presence. Again, it’s not significant at this point. I mean, it’s a couple of dollars a day which again, if you’re an option buyer, maybe you're willing to pay that premium, if you’re an option seller, you’re collecting this as little income on the way, but it’s not significant really that much yet. Now, we get down to the contracts which are just 11 days to go until expiration, so 11 days and now we see that Theta decay is now up to .7. Now, Theta decay is really starting to increase. Now, every day, you’re losing about $7 in value no matter where the stock goes. Again, the stock can still increase in price and that can overshadow or offset the Theta decay, but basically, your option contract has to figure out a way to gain at least $7 of value or more to compensate for the increased Theta decay. It’s got to gain that much value or more. Now that we down to the weekly options which at the time I’m doing this recording are about two days away from expiration, now we see the Theta decay of $15 a day. This is crazy because the at the money options are worth $36, so you can see in about two days, they’re going to be worthless. Now, you can start to see the impact of just a single day on these contracts, how it just exponentially increased the impact and the decay on the contracts. We went from a dollar to a couple of dollars to $7 and now, we’re getting to like $15 of Theta decay in these contracts which is pretty significant. As you get closer to expiration, the need for the stock to make outsized moves, meaning like unexpected huge large magnitude moves to compensate for this Theta decay becomes really apparent. That's why for option sellers, this is when we really start to increase our potential profit, is inside this 30 day, 45 ish day window. That's when Theta decay starts to really accelerate on contracts and hence, why we found in back-testing, that ends up being a pretty good time to enter short premium trades because we start to take advantage of that at the most optimal time. Hopefully that helps out in just understanding how this works. Again, it’s another avenue to options pricing which is not your typical straight line path that stocks follow where the stock goes up, you make money. With options contracts, a stock can increase in value or decrease in value and depending on how your structure and how the trade is structured, you could lose or increase your potential profit. Theta is one of those things that’s just this constant erosion of value that gets paid by option buyers and then ultimately gets collected by option sellers. Hopefully this helps out. As always, if you guys enjoy these, let me know. Please post a review if you’ve been following along in some of these daily calls. If you haven't yet, that’s the best way that you can help us out. Spread the word about what we’re trying to do here at Option Alpha. Again, if you haven’t posted a review online in iTunes or Google or iHeartRadio or wherever you listen to, please help me out by doing that. As always, if you guys have any questions, let me know. Until next time, happy trading!