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"Which Option Has the Fastest Time Decay?"

Question By Ashok Bhandari

"Which Option Has the Fastest Time Decay?"

Which of the following option's time value will reduce sharply as compare to others as days progress? In The Money, At The Money or Out of the Money?

Asked on 13 June 2011

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Answered by Mr. OppiE

Hi Ashok,

Which option has the fastest time decay? This is an extremely important options trading question for all beginners and you are right to investigate its answer from the perspective of options moneyness.

The options greek that governs rate of time decay is "Theta". Generally, Theta decreases as options get more and more in the money or out of the money and as time to expiration increases. Yes, the nearer an option is to expiration, the higher its theta value would be and the faster its rate of time decay versus options with longer expiration. Because At the Money options have the highest Theta value compared with in the money options or out of the money options, the time value (extrinsic value) of at the money options generally decline faster than ITM or OTM options.

At the money options also contain the highest amount of extrinsic value which is also why its theta value will always be higher than ITM or OTM options which have a lot lesser extrinsic value. However, if you are looking to write options which you can profit from quickly before expiration, then writing OTM options would actually make quicker profit than writing ITM or ATM options. Why is this so?

Even though At The Money Options have the highest theta value and would have a much higher time decay in terms of absolute dollars than ITM or OTM options, options don't go through time decay in a linear fashion. In fact, OTM options would lose more of its extrinsic value further from expiration than ATM or ITM options. OTM options actually lose most of their value before their last 30 days whereas ATM and ITM options lose most of their value in their last 30 days. See a chart of the different rate of time decay.

As such, in order to maximize profitability of writing options which has more than 30 days to expiration, it might be better to write Out of the money options and if you are writing options with less than 30 days to expiration, writing At The Money options might be better.

In conclusion, At the money options generally have a higher rate of time decay and have a higher amount of extrinsic value available for time decay. However, as out of the money options go through time decay fastest more than 30 days away from expiration, that might be a better choice if you are writing options with longer expiration. Take note also that writing OTM options subject you to a smaller possibility of your position getting assigned which results in higher chance of profitability. However, specific situations do differ and you need to apply what makes the most sense to your current options strategy and outlook.

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Response by Ashok...

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