Last week we introduced a new series on how to use the magical and much-loved greek, theta. In part 2 we will push further toward our objective of cash flow mastery.

Let’s make sure we fully grasp why time is a valuable commodity for options contracts. The answer lies with the notion that stocks move over time. Apple shares can make a larger move over one month than a single day. Thus, it’s logical that you’d be willing to pay more for a one-month option than a one-day option.

There are times when this isn’t true, however. Can you think of a situation where a stock isn’t expected to move – no matter how much time passes? Think about an acquisition (when one company buys another). When the news hits, the company being acquired usually gaps up near the buyout price and then drifts sideways for months until the deal completes.

For example, if a company whose shares were trading for $50 announced they accepted a buyout offer to purchase the business for $75 a share, then the stock would gap up close to $75. After the news and subsequent stock jump happens, all options would see their extrinsic value dwindle toward zero – even if they had a year remaining. See, it’s not just time, but also volatility. I wrote an article on why so-called volatility value should get more love. For extra insight, read it.

Theta Acceleration

In part one we stated that Theta is highest for short-term options. The beautiful decay curve provided the visual that you should etch in your mind. Now, here’s a numerical illustration:

The blue box highlights the four months being displayed: Aug, Sep, Oct, Nov. On the left side, the red box highlights the Theta for each month’s option. Take note of the acceleration. The longest-term option (Nov) is only losing 7 cents per share per day. That translates into $7 per day per contract (remember one contract controls 100 shares). The shortest-term option (Aug) is losing 23 cents per share per day.

Traders seeking to capitalize on Theta fully would want to sell Aug options, not November. That way they’re capturing $23 per day instead of only $7.

What of Strikes?

Interestingly, not every strike price in the same month carries an equal theta – even though they have an identical amount of time remaining. Because extrinsic value (aka time value) peaks in ATM options, they must necessarily lose the highest dollar amount per day. Consider the following graphic.

The vertical axis is “time value” but could also be labeled “Theta.”

Let’s take another look at the option chain, this time focusing on a single month. Each one of these options expires in 42 days. They have the same number of days until death. And yet, some are losing $2 per day while others are losing $9 per day. The difference is the strike price. I’ve drawn a yellow line to illustrate the same bell curve shown above, but the axis has been flipped. Note the hump of the curve is over the ATM strike. As we move further OTM or ITM, the theta shrinks.

The application of this theory is simple. If you want to sell options that provide the highest potential gain due to time decay, you should sell ATM options. This is why our beloved Tackle 25 system involves selling 40 delta covered calls and not 20 or 10 delta options. You get more payment per day, a higher theta.

Next time we’ll dive a little deeper.

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