“Please remain on the line and the next available representative will be with you shortly [elevator music resumes].”
WAITING! Yeah. It’s annoying. But we have to do it. And when the wait is over, we finally get what we want…just like theta.
How Does Theta Work in Options?
The first thing we need to talk about is: How does theta work in options? This is not a big mystery. The option Greek “theta” measures how much an option loses per day from time passing—a phenomenon called time decay, or option erosion.
If you think about it—and this is not necessarily intuitive UNTIL you think about it—options lose value as time passes because they have less time to gain value as each day passes. And THAT is how option sellers make money: by waiting for time to pass.
But what if we can wait less time and make more money? Is this even possible?
We left-brained option traders LOVE to measure things. As I like to say, “What is measured is optimized.” When we can put a number on it, we can make better decisions. We can literally select the option that gives us the greatest advantage for our trade each and every time when we use the option Greek theta.
When Does Theta Decay Most?
That begs the question: When does theta decay most? If we can answer that question, we can gain an advantage over other option traders who are not quite as savvy. When we sell options, we want to get the biggest positive theta possible. (Note: There are other factors to consider and balance this ideal against. But all else held constant, when it comes to theta, size matters. Bigger positive theta is better.)
There are two factors that are useful rules of thumb when it comes to theta: moneyness and term structure.
There’s a word we don’t get to throw around in everyday use. An option’s moneyness is the proximity of the strike price from the stock price. Simply put, it’s how in or out of the money it is. With theta, the closer to being at the money, the higher it is. Both in-the-money and out-of-the-money options will have lower theta than at-the-money options. So, when we sell options, selling closer to the money can give us an advantage (again, all else held constant).
I know. I’m just full of fancy words today, aren’t I? When we look at options with the same strike price but different expirations, they will have different thetas. (And that’s all term structure means: same strike, different expirations.)
Near-the-money options with less time till expiration have higher theta than options with more time till expiration, given they are the same strike price. This is another way traders can get an edge and trade more profitably in the long run. (Yeah. The more you learn, the more you earn, when it comes to option trading.)
Options Rules of Thumb Limitations
Options rules of thumb are super useful. But remember the old Russian proverb Ronald Reagan used to throw around, “Trust but verify.” Any options-friendly broker will have option theta as an available column in the option chain. Use it! The rules of thumb provided above are just that: loose rules to quickly gauge the situation BEFORE looking at the actual situation. Go and look at the actual theta value on every trade. It’ll ensure you’re maximizing every opportunity and making that wait as short as possible to get to your profit target.