"How Does Time Decay Work in Credit Spreads?"

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"How Does Time Decay Work in Credit Spreads?"

"How do you benefit from time decay in credit spreads if you are profiting from time decay on the short but losing on time decay on the long?"
- Asked By Baruch on 13 Feb 2014

Answered by Mr. OppiE

Hi Baruch,

Indeed, in a credit spread, you are holding both long and short options and since both long and short options are subjected to time decay, how does credit spreads make a profit when you are making a profit from time decay on the short options and making a loss at the same time from time decay on the long options?

Even though it is true that all options are subject to time decay, the RATE of time decay as well as the AMOUNT of extrinsic value available for time decay are both different. It is exactly the differences between these two factors that allows credit spreads to produce a net profit even though both long and short options are decaying at the same time.

All options experience time decay at a different rate. Some decay faster and others decay slower. Credit spreads generally use short options that decay faster than the long options. The rate of time decay is governed by the options greek called "Theta". Credit spreads usually use short options with a higher theta than the long options bought. That difference between the rate of decay produces a net profit even though both long and short options are decaying at the same time.

Difference in Rate of Time Decay in a Credit Spread QQQ is currently trading at $89.81 and its April $90 Call Options are trading at $1.82 with a theta of 0.0175 and its April $92 Call Options are trading at $0.97 with a theta of 0.0145. Assuming you are moderately bearish on QQQ and wish to profit from a moderate downside move using a Bear Call Spread. Sell To Open 10 contracts of April $90 Call = $1820, theta 17.5 Buy To Open 10 contracts of April $92 Call = -$970, theta -14.5 Net Credit = $850, Net Theta = 3 The overall difference of 3 theta between the short and long option ensured that time decay is in the favor of this credit spread position as a positive theta of 3 suggests that all else unchanged, this position will gain an approximate net profit of $3 a day from time decay alone.

Secondly, the amount of extrinsic value available for time decay between the short and long is different as well. Credit spreads work by having more extrinsic value available for time decay on the short options than there is on the long options. In the example above, both April $90 and $92 Call are out of the money. This means that both options consist only of extrinsic value. It is clear that the short April $90 Call has a higher extrinsic value than the April $92 Call and when both options expire out of the money when QQQ moves downwards, a net profit in the amount of the net credit of $850 is realised when you make $1820 on the short options and lose $970 on the long options.


In conclusion, credit spreads work even though both long and short options are subjected to time decay at the same time due to the long and short options having different rates of time decay as well as different amount of extrinsic value available for time decay. Of course, time decay is not the only way all credit spreads make a profit even though it is the primary profit driver for neutral credit spreads. For bullish or bearish credit spreads, movement in the underlying stock can actually make a bigger difference to profitability than time decay.