Option�s TIME VALUE � Putting It Together � Part 4: Behavior

The Behavior of Time Value
As mentioned in Part 3, the Time Value component of an option price will decline or �erode� as expiration is nearing (i.e. Time Decay).

The rate of decline of option�s time-value resulting from the passage of time (i.e. rate of Time Decay) is known as THETA, which is one of the Options Greeks.

Comparing Theta at a certain point of time between ATM (At-The-Money), ITM (In-The-Money) & OTM (Out-of-The-Money) options, Theta is typically highest for ATM options, and gradually decreases as options move towards ITM and OTM.
This is understandable because ATM options have the highest time value component, so they have more time value to lose over time than an ITM or OTM option.

Comparing Theta over time, there are different behaviors between ATM and ITM / OTM options:
For ATM options, as the Time Value component of an option price decreases when the option is approaching expiration, the rate of time value decrease is accelerating (i.e. Theta is increasing) as it is getting closer to expiration.
This means that the amount of time value disappearing from the option price per day gets bigger with each passing day. For ATM option, time value decreases sharply particularly in the last 30 days before expiration.

On the other hand, for both ITM & OTM options, Time Value actually decreases at a decelerating rate as expiration nears. In other words, Theta decreases as the option is approaching expiration.
This means that the amount of time value disappearing from the option price per day gets smaller with each passing day.

This Time Value behavior can be seen in the following graphs:

1) Time Value of ATM Option:






2) Time Value of OTM Option:




Note: Both pictures courtesy of Sigma Options

Therefore, based on the above, we can summarize as follow:

For ATM options, Theta (i.e. the rate of time value decline as the time passes) is typically the highest (as compared to ITM & OTM options), and will be increasing (i.e. the rate of time value decrease is accelerating) as the option is nearing expiration.

For both ITM & OTM options, Theta is relatively lower (than ATM options), and will be decreasing (i.e. the rate of time value decrease is decelerating) as the option is nearing expiration.

The Impact of Implied Volatility (IV) on THETA
Theta will also be affected by the changes in Implied Volatility (IV).
When IV decreases, Theta will be higher, particularly when it is nearing to expiration.
On the other hand, when IV increases, Theta would be lower.

Why is it so?
As previously discussed in Part 1, the level of Time Value of an option could basically be associated with the level of uncertainty as to whether or not an option can finish ITM.
The more uncertain as to whether an option can or cannot finish ITM before or at expiration, the higher the time value will be.

When Implied Volatility decreases and the option is nearing to expiration, such uncertainty will be lower.
Since Theta is the rate of time decay, when IV decreases, Theta will be higher (i.e. the rate of time value decrease due to the passage of time will be faster).
This is because higher Theta would consequently result in lower time value, which reflects the lower level of uncertainty due to lower Implied Volatility.
And this is particularly so when the expiration is nearing, because the underlying stock price will have lesser time to move, and therefore have even lower probability to finish ITM (i.e. even lower level of uncertainty).

Related Topics:
* FREE Trading Educational Videos You Should NOT Miss
* Options Trading Basic � Part 1
* Options Trading Basic � Part 2
* Understanding Implied Volatility (IV)
* Option Greeks