Time Decay

  

Categories: Derivatives

See: Theta Decay.

It sounds like what happens when you don't floss, but it actually refers to the way that the time value of a stock option decays or declines with time.

The closer to the expiration date, the smaller the time value of the option. (Time value: as in...if you had an option to buy KO for $50 when KO is today trading at $42, and that option expired in 2 weeks, it probably wouldn't be worth much, because the odds of KO trading much above $50 in the next 2 weeks is relatively low. But if you had Theta (or time) of 3 years before the option expired, then yeah, that option could be worth a ton.)

Example:

You sold puts on GOOG at $450 for $35 which expire in 4 months. The stock today is at $600. That is, you sold the right for someone to make you buy shares of GOOG at $450 any time between now and 4 months from now for 35 bucks. Things go along and, well, GOOG just stays pretty flat, doing a whole lot of nothing.

It's now 3 days before those put options expire (we've gone 3.9 months with a whole lot of nothing happening in GOOG). The stock is still around $600 a share. What are the odds it plummets $150+ in 3 days? Really low. So the value of those puts is almost fully expired—its Theta has decayed to just 3 days' worth of trading time, and it is highly likely you just collect your 35 bucks, walk away, and buy yourself a really nice burger at a Manhattan eatery.

Related or Semi-related Video

Finance: What Is a Put Option?83 Views

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finance a la shmoop what is a put option? hot potato hot potato

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ow ow! yeah remember that game well nobody wanted the potato, poor thing. the

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players wanted to put it in someone else's hands. well put options kind [glue put around a flaming potato]

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of work the same way. a put option is the right or option or choice to sell a

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stock or a bond at a given price to someone by a certain end date.

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all right example time. you bought netflix stock at the IPO a zillion years

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ago at $1 a share. that's you know splits adjusted. all right now it's a hundred

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bucks a share. if you sell it you pay taxes on a gain of 99 dollars a share. in

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California that would be a tax of something like almost 40 bucks. well the

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stock was a hundred but you keep only something like 60. feels totally unfair.

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right so you really don't want to sell your stock but you're nervous about the [graph shown]

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next few months that Netflix will crater for a while and go down ten

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maybe twenty dollars. longer term though you think it'll hit 300. so this is the

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perfect setup to maybe look at buying some put options on Netflix. if the stock

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goes down your put options go up. with Netflix volatile but at a hundred bucks

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a share ,you look up the price of an $80 strike price put option expiring in

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December, and you know that's mid-september now .for five bucks a share

01:33

you can protect your stock for the next few months .think about it like temporary [stocks placed in vault]

01:37

term life insurance. you pay the five dollars a share in the stock goes down

01:41

to 82 by mid December, worst of all worlds. well not only did you lose the $5

01:48

a share but your stock has lost $18 in value. but had Netflix really cratered

01:55

and gone to say $60 a share well you would have exercised your put and sold

02:01

your shares at 80 bucks. well those put options you paid $5 for

02:06

would be been worth 15 bucks a share. in buying that put option you've [equation shown]

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guaranteed that your loss will be no more than a $75 value for your Netflix

02:16

position at least for that time period and ignoring taxes. well remember that

02:21

options expire after December whatever like the third Friday of the month it's

02:26

usually when options expire, you then have no protection and your shares float

02:31

along naked. naked? really who knew accounting could get so [paper put option goes "skinny dipping".]

02:36

raunchy. yeah well that's naked put options.

02:40

that's what they really are people.

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