What is options theta?

If you’re new to options trading, or an old pro, you probably understand that all options contracts expire. When you purchase an options contract, you pay a premium. As an options contract expires, it loses value or the premium you paid for it. A formula is used to describe how quickly an options contract loses its value based on time. This formula is known as theta. 

Traders need to understand this concept because it can help them make better trading decisions. So what is options theta? And how can you use it to your advantage? Keep reading to find out!

Key takeaways

• Theta is the measurement of time value in an options contract. 
• Theta can be negative or positive, meaning it can measure the loss or gain of value in an options contract. 
• Theta hurts options contract buyers and helps options contract sellers.  
• Theta decay is not fixed. The closer an options contract gets to expiration, the faster theta decay is. 

What is options theta (and why should you care)? 

Theta is one of the Greeks that measures how much an option’s price will change given a one-day change in time. In other words, theta tells you how much premium your options contract loses in value in 24 hours. Why is this relevant? If you’re buying a long call or put options contract, theta is robbing you every day that you hold onto the position. The closer the contract gets to expiration, the less value it has. Theta decay is one of the main ways that options traders lose money. If you want to trade profitably, you have to calculate how long you will hold the position and how much money you will lose from theta decay. 

However, theta isn’t all bad news. If you sell options contracts, also known as writing premium, theta decay tells you how much premium a trade will earn every 24 hours. Writing premium means that theta is working in your favor and can drastically increase the odds of your profitability when selling options. 

Why do options lose value over time?

Options contracts have two types of value. Only one of these values is affected by the passage of time. That value is known as extrinsic value. 

Extrinsic value is sometimes referred to as the “time value” of an options contract, but this is only a partially accurate description. It is important to note that Vega or implied volatility also affects the extrinsic value. However, for this discussion, we will only focus on the time value or theta.

An option’s time value is the cost a trader is willing to pay above the option’s current market price. Traders are willing to pay higher premiums for more time since this will give a trade more time to work out favorably. Traders are willing to pay less premium for options contracts with less time until expiration because this decreases the time the trade will have to be profitable. 

How fast does theta decay?

Theta decay is not linear. What does this mean? It means that the rate of decay is not fixed. As an options contract approaches expiration, the rate of theta decay increases, and as a result, the extrinsic value of the options contract decreases. In layman’s terms, this means that the closer an options contract gets to expiration, the less it’s worth. 

To visualize what this looks like, let’s examine the hourglass. In the video below, notice how much faster the hourglass empties on the right vs. the left. The hourglass on the left would represent an options contract with a lot of time value or more than six weeks until expiration. The hourglass on the right would represent an options contract with less than one week until expiration. 

As you can see, the closer an options contract approaches expiration, the faster it loses extrinsic or time value. Why is this relevant? If you buy a short-dated, out-of-the-money options contract, it will lose value quickly. If you do this enough, you’ll blow out your trading account. This is one of the biggest and most common mistakes new traders make. 

You can determine the rate of theta decay by finding this number in the options chain. If theta is not viewable on your options chain, you may need to change the parameters.

Do you want positive or negative theta decay?

It depends on the type of trade you want to take. A better question is, how much theta decay can you tolerate? The best way to limit exposure to negative theta on directional trades is by buying options contracts with more than six weeks to expiration. See the slide below for buying directional trades. 

In Conclusion

Theta decay can make or break your trading career. Those who learn how to master theta improve the odds of each trade being more profitable. Traders who do not understand theta will continue to pay the piper until there is no more money to pay. Theta is the enemy to option buyers and the friend of option sellers. Theta can be negative or positive or neutral, depending on the type of trade setup you have. Many traders make a living trading theta, or writing premium. Theta positive trades are typically much higher probability because it puts time decay on your side. If you want to learn how our professional traders use theta to setup winning trades, consider joining our free trading room. We discuss the core concepts of options trading and answer questions that new traders might have. We know you’ll find the value. See you there!

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