Option prices have two components - intrinsic value (portion in the money) and extrinsic value (time premium). Modeling the prices of options is very simple at expiration because all of the extrinsic value has been evaporated, and only the intrinsic value is left. Theta is the option traders term that represents the rate of decay in the time value of options.

Theoretical option prices at times other then expiration day can be calculated using the Black Scholes model. For an option spread, such as the bear call credit spread, it is crucial to understand how time decay affects the value of your positions. Take a look at the following example:

Assumptions:

  • Russell 2000 index closes August 14 trading at 754.38
  • Enter a 780/790 September bear call credit spread on the Russell 2000 on August 14
  • Sell to open the September 780 for $10.4 ($1040 per contract)
  • Buy to open the September 790 for $7.6 ($760 per contract)
  • The net credit is $280, and the risk is $720 ($1000 spread - $280 credit)
  • The potential percentage gain on this trade is 28% for only 36 days, but the potential loss is 72%
  • Assume 20% implied volatility for the life of the spread

With the above trade, if the Russell 2000 closes on September expiration (19th) at less then 780, then both call contracts will expire worthless, and the profit is the $280 initial credit collected. However, the credit spread could show significant paper losses prior to September expiration, even when the Russell is below that critical 780 level. And closing the position early would require realizing those paper losses early by buying the spread back for a debit that could be larger then the initial credit received.

The graph below models the value and time decay of the spread, starting from August 14th all the way through September 19th expiration. Take note of the the following:

  • The break even point on expiration day is 782.8. (780 + 2.8 initial credit received)
  • The yellow line represents the theoretical gain or loss on August 23rd, 27 days prior to expiration
  • If the Russell hits 780 on August 23rd, the spread position would show a significant paper loss (roughly $190), even with the Russell below the 782.8 expiration day break even point.

Key takeaways:

  • When trading options, it is crucial to understand how time decay affects the value of your positions
  • It is also crucial to plan your exit, or adjustment strategy prior to entering the trade

For related reading:

Also, I recommend the book below for detailed info on option adjustments. Purchase directly from the link below to help support the geldpress site.

The Option Trader Handbook: Strategies and Trade Adjustments (Wiley Trading)
The Option Trader Handbook: Strategies and Trade Adjustments (Wiley Trading) by George Jabbour

Disclaimer: Option trading is dangerous and you can go broke and wind up homeless or working as a fry cook at a burger joint. Trade at your own risk. There are no guarantees as to the accuracy of the above information!