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Trading options for income: Theta decay

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In our quest to understand trading options for income, we often consider the impact of time (theta decay) on the extrinsic value of our option position. There are two factors that will affect theta decay: DTE (days till expiration) and how far OTM (out of the money) the option's strike is located.

It is well known that an ATM (at the money) option, with 30 DTE (days till expiration) or less, will experience an exponential decline in value due to theta decay; whereas, an OTM option will experience a somewhat linear decline in value.

To determine the impact of theta decay on OTM options, Tasty Trade recently conducted a test of the SPX by placing short Strangle positions at 80 percent OTM during periods of minimal price movement and minimal change in IV (implied volatility). Three trades were placed with a hold period of 30 days: the first with 60 DTE; the second with 45 DTE; and the third with 30 DTE. The impact of theta decay on value was plotted for all three (the x-axis represents the 30 day hold period; not DTE) and quantified in a table.

The results: all three DTEs exhibited a fairly linear decline in value due to theta decay (as expected for OTM options). When comparing the differences between the three, the 45 DTE showed a slight edge in P&L at $616 (vs. $514 and $568 for 60 DTE and 30 DTE respectively).

In conclusion, since we don't know how may positions were tested or the average percent change in price and volatility, it is difficult to assign a high degree of reliance on this data. We do know, from our own testing, that Weekly theta decay exhibits different behavior than the Monthly.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.