Trading options can be a long and frustrating journey without discipline and solid understanding of the option greeks, including option theta, and how to use them in your trading. Most option traders know there is a time component to options. But surprisingly, many do not have a firm grasp of what that really means. Below we will examine option theta so you can feel more confident and make better decisions as an option trader.
What Is Option Theta?
Option theta measures the rate of decline in the value of an option due to time passing. Keeping it simple, for every day that passes theta should decrease the option’s premium by the amount of theta. Like a life insurance policy, for example, options eventually expire. The rate that option premium declines is measured by the current theta. Option theta is not linear but accelerates as expiration approaches. For example, shorter expirations will have larger thetas and longer expirations will have smaller thetas all else being held constant. In addition, theta increases as expiration approaches especially for at-the-money (ATM) options.
Why Is Theta Highest at the Money?
ATM options have the highest amount of time decay, so they also have the highest theta. Out-of-the-money (OTM) options are also composed of all time premium and no intrinsic value (the amount the option is ITM) – just like ATM options but to a lesser degree. In-the money (ITM) options have smaller thetas than ATM options in addition to intrinsic value. As a buyer of options, picking the strike price to minimize time decay can play an integral part as well as giving an option trader an edge versus a larger theta that an ATM option has.
Can Option Theta Be Positive?
Is option theta always a bad thing? Time passing will always decrease option premium keeping all other variables constant. Long options (both calls and puts) have negative theta, so time passing will decrease the premium. To profit on a long option, the trader needs to sell it for more than it was purchased. Theta is considered negative because it will decrease the premium with each day that passes. Short options have positive theta because premium is decreasing, but that is beneficial for a short position. A trader profits if premium is sold and bought back at a lower amount or it expires worthless. Time passing (a.k.a. positive theta) will do its part to decrease short premium as each day passes.
Negative and Positive Theta Examples
Let’s take a look at examples of positive and negative theta and how each is calculated for the option premium. Below is an example of an option chain for a long call position.
The trader bought the 120 call and its current premium is 9.75 with a negative theta of 0.05 (rounded up from 0.04891). Theta is considered negative because it is a long option and, in this case, a long call. Keeping theta constant, although it should continue to increase as time passes and the option moves closer to expiration, the premium will decline due to time passing. If 5 days pass and keeping all other variables constant, theta should decrease the premium by about 0.25 (5 X 0.05) dropping the premium to about 9.50 (9.75 – 0.25). There is negative theta going to work.
For the option chain below, the same strike and expiration were chosen but this time the position is a short call.
So now, the position has positive theta (short call). Time passing is an asset for this position. So, if 10 days pass and once again keeping all other variables constant, the new premium would approximately be 9.20 (9.70 – (10 X 0.05)). The position has benefitted from a 0.50 (or $50 in real terms) drop in premium.
There is more to option theta than knowing it is just time decay. Using it effectively and wisely as an option trader can give you a considerable edge. Not understanding the ins and outs of theta can leave you wanting more time, and time is something you can never get back.
Senior Options Instructor
Market Taker Mentoring, Inc.