When does theta decay really kick in?

[Function 0]

I have a question about Theta and its effect on option prices. The Black Scholes formula takes into account the number of days before expiration in its calculation for the decay of time value, but is it being calculated by discrete days or is it instantaneous? In other words, is the option value decaying throughout the day or only with each passing day? The question is not too dissimilar to "how often is interest being compounded."

The reason I ask is because I am generally selling OTM options close to expiration. In most cases the time value decay is mild, but as things get closer to the expiration date, each day can matter a lot and I want to take the knowledge in my trade construct.

Thanks everyone!

[DubMcDub 122]

Time decay can occur both during trading hours and overnight. 

 

You probably know this, but keep in mind that Black-Scholes (and other options pricing models) are just models.There is no way to perfectly, or even near perfectly, calculate time decay with precision, because the only thing that actually affects an option's price is the order flow. For example, if buyers suddenly decide they're willing to pay more for an option near expiration, the option could stay the same price (or even increase) despite what should be strong time decay. This can happen even if the stock price hasn't moved. The options pricing model would explain this phenomenon by increasing the option's IV (i.e., the IV increase offsets the theta). 

 

Not sure if this fully answered your question, but hope it helps somewhat. 

[skydragon 51]

@Function It can be difficult to accurately calculate actual theta effects (for reasons mentioned by DubMcDub, plus other factors).  The rapid acceleration of theta effect when expiration date approaches is well documented on the www (with some great graphs).  That will give you a general idea.  If you are looking for a specific date/time, then you will likely find the answer illusive (if not non-existent).

   An enlightening illustration is considering how theta is handled over the weekend.  There is mention in at least one article at SixFigureInvesting.com (and likely elsewhere) that the Money Makers begin tweaking option pricing on Thursday so that all the upcoming weekend theta effect is absorbed before market close on Friday (to avoid a Friday-to-Monday price jump).  So the math goes from being complicated to being subjective.