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Published On: Mon, Nov 26th, 2012

Options Theta Explained

The fact that an option has an expiration date has given rise to the concept of Theta. A 3-month option, for example, stops existing after 3 months. If it hasn’t reached the strike price by that date, it expires worthless. That implies that the option loses a certain percentage of its value every day. This daily loss is what we refer to as options Theta.

Example 

An option with a Theta of 0.015 will, if everything else remains the same, be worth $0.015 less tomorrow than today. And the day after it will be worth another $0.015 less. Someone buying an option with a value of $1 will therefore find that the next day the value would have dropped to $0.985 and the day after that it will be worth only $0.97.

Positive and negative Theta 

There’s an important point to take into consideration here: Long stock options have negative Theta values and short stock options have positive Theta values. That simply means that the value of long options decreases over time, while the value of short options positions increases over time. This is why Theta is often described as an option buyer’s enemy and an option seller’s friend.

Theta and time to expiration

Another important factor to keep in mind is that Theta is not constant. The Theta at which one buys or sells an option will most likely not be the same the next day. This is because time decay does not happen in a straight line: Time value decay fairly slowly when there is a lot of time to expiration and it decays faster during the last 30 days before expiration. That is why many options buyers prefer longer term options and options sellers often prefer shorter term options.

Theta and Moneyness

It is also important to note that Theta is different for the various ‘Moneyness’ states of an option. At the Money options have the highest Theta rate, but this declines fairly sharply for Deep in the Money options and Out of the Money options. The reason for this is that far ITM options and far OTM options do not have a lot of extrinsic value, so there is little left to decay.

The importance of Theta

Options Theta is very important for traders who are entering into a Theta-based neutral strategy. An example of such a strategy is the well-known calendar call spread, where the trader attempts to benefit from the decay of the options’ extrinsic value.

On the other hand, Options Theta is not of that much concern for a trader entering into a directional options trade such as the popular bull call spread, where the trader usually plans to hold the position until the expiration date.

An options trader who is speculating on a relatively small short term move in the price of the underlying asset must ensure that he or she buys options with a Theta rate which is as low as possible so time decay does not completely cancel out the small profits that can be expected from such a trade.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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