Theta: What It Means in Options Trading, With Examples

What Is Theta?

Theta, the Greek letter θ, is used to name an options risk factor concerning how fast there is a decline in the value of an option over time. This is also known as an option's time decay. As an option gets closer to maturity or the contract's end, it loses value as long as everything is the same.

Theta is generally expressed as a negative number for long positions and a positive number for short positions. It can be thought of as the amount by which an option's value declines daily. For instance, a theta of -0.05 indicates that the option's price will decrease by five cents per day.

Understanding Theta

Options give the buyer the right to buy or sell an underlying asset at the strike price before the option expires. The strike price, also called an exercise price, is set when the contract is first written for the price the underlying asset must reach before the option can be exercised.

Options Greeks, or simply “Greeks,” are invaluable tools for these investors. The mathematical variables help investors calculate the risks that influence an option’s price, especially as it nears its expiration.

Time is one of the risks for option buyers since options are only exercisable for a certain period. Simply stated, an option’s profitability decreases as time goes on. Theta measures the time decay or erosion of an option’s value as time passes.

What happens when two options are similar and one expires after a longer period? The value of the longer-term option is higher since there is more time during which the option could move above the strike price.

Theta is generally expressed as a negative number for long positions. The option's value diminishes as time passes until the zero time value when the option expires. This is why theta is good for sellers and not so for buyers—value decreases from the buyer’s side as time goes by and increases for the seller.

Hence, selling an option is known as a positive theta trade: as theta increases, so do sellers’ earnings on their options.

Time Decay and Option Values

If all else remains the same, the time decay causes an option to lose extrinsic value or premium as it approaches its expiration date. Therefore, theta is one of the main Greeks that option buyers should pay attention to, given that time is not on their side if they are long option holders.

Conversely, time is on the side of the investor who writes options. Option writers benefit from time decay because options become less valuable as the time to expiration decreases. Consequently, it is cheaper for option writers to buy back the options and close out the short position.

Put differently, option values are, if applicable, composed of extrinsic and intrinsic values. At option expiration, all that remains is the intrinsic value, if any, because time is a significant part of the extrinsic value.

Theta vs. Other Greeks

The Greeks measure the sensitivity of options prices to their respective variables.

For instance, the delta of an option indicates the sensitivity of an option's price in relation to a $1 change in the underlying asset, while the gamma indicates the sensitivity of an option's delta with regard to a $1 change in the underlying security.

Vega indicates how an option's price theoretically changes for each one percentage point move in implied volatility.

Example of Theta

Imagine you’re interested in buying a call option for a stock named “TechCo.” The stock is trading at $50, and you’re looking at a call option with a $52 strike price, expiring in 30 days. This option costs $2 per share or $200 for a standard options contract that covers 100 shares.

Suppose the theta for this option is -0.05. If everything else (stock price, volatility, interest rates, etc.) stays the same, the option will lose five cents per day in value just because time is passing.

Fast forward 10 days, and you find that TechCo’s stock price hasn’t changed. If all else stayed the same, the value of your option should have decreased only because of theta or time decay. Specifically, you’d expect a drop of 50 cents (10 days multiplied by the theta, -0.05) in the option’s price. That would mean your $2 option is now worth $1.50.

Hence, understanding theta helps you grasp how the ticking of the clock affects your options investments. Time decay gradually erodes an option’s value as the expiration date approaches. Knowing this can help you make more informed decisions for your trading strategy.

The Bottom Line

Time decay isn't just a theoretical concept in options. It's a noteworthy factor that can erode potential profits for buyers while benefiting sellers. Whether you're taking a long position buying an option or writing options, understanding theta can make the difference between a profitable trade and a losing gamble.

If you're an option buyer, time is not on your side since it gradually saps the value of your investment. Conversely, time decay becomes your ally if you're on the selling end, making it cheaper to close out your short position as the option's value decreases. Armed with an understanding of theta and how it connects to other market variables like volatility, you can better manage the risks associated with your investment strategy.