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Myth of (exponential) time decay?
- Thread starter rselitetrader
- Start date
Quote from rselitetrader:
The magnitude of theta rises exponentially as expiration approaches (exponential time decay) --- ONLY and ONLY --- for ATM options. Theta is more or less flat and decreases to nearly zero prior to expiration rather than increases exponentially. If an option is ATM now, it likely will not be one minute later, and much less likely to remain ATM one month later. Therefore, if you short options, you will have some time decay, but will not have the benefit of EXPONENTIAL time decay on your side (you don't have the benefit of the most powerful weapon; you only have a toy BB gun against your opponent).
CBOE, OIC, and many others have taught investors exponential time decay, but I think it is misleading. Any comments?
Depending on how you look at it. Theta is not a pure exponential function of time. Theta has a factor which is an exponential function. Look at the theta formula.
Also the bid ask quote is not continuous, so it won't follow a continous function. For example, 5 days before expiration, a FOTM option is quoted 0.05 and 0.1. This bid ask quote will not change for 2 or 3 days, and the last day it changes to 0 and 0.05. Only when the quote is large enough, we can approximate the discrete quotation by a continous function.
In practice, it is fair enough to say it is exponential time decay if we allows a certain margin of error. Traders are not mathematicians. You cannot use pure math perspective to look at trading.
There exists a relationship between volatility and time and it is as follows.Quote from Profitaker:
"Synthetic time" Please explain ?
An increase in iv has the same effect as an increase in time to expiry - thus 'synthetic time'. The reverse obviously also holds true, i.e if there is more time to expiry then that has the same effect as an increase in iv, iow premium goes up.
db
Quote from rselitetrader:
The magnitude of theta rises exponentially as expiration approaches (exponential time decay) --- ONLY and ONLY --- for ATM options. Theta is more or less flat and decreases to nearly zero prior to expiration rather than increases exponentially. If an option is ATM now, it likely will not be one minute later, and much less likely to remain ATM one month later. Therefore, if you short options, you will have some time decay, but will not have the benefit of EXPONENTIAL time decay on your side (you don't have the benefit of the most powerful weapon; you only have a toy BB gun against your opponent).
CBOE, OIC, and many others have taught investors exponential time decay, but I think it is misleading. Any comments?
This is not correct. Simply refer to a B-S model and take a careful look at the relation between option value and time variable.
DaddyQuote from daddy'sboy:
There exists a relationship between volatility and time and it is as follows.
An increase in iv has the same effect as an increase in time to expiry - thus 'synthetic time'. The reverse obviously also holds true, i.e if there is more time to expiry then that has the same effect as an increase in iv, iow premium goes up.
db
I take your point, but I wouldn't say an increase in IV "has the same effect as increasing time". Adjusting one or both parameters to arrive at an option price maybe do-able, but there will be significant differences in the greeks, especially Theta.