Options Theta

Options Theta Explained

Options theta is one of the options for Greeks. Theta measures the sensitivity of the decline in extrinsic value with time. This is why buying naked options contracts is a risky trading strategy. Especially avoid buying out-of-the-money options contracts.

They are cheaper, yes; however, the theta will eat away at your options contract rapidly because your options contract will be less likely to expire in the money. 

Options theta is an important factor when purchasing an options contract. They are decaying assets, and theta plays a key role in options losing time value

Options Theta is a part of the Greeks‘ options trading. There are many moving parts to options trading. Hence the need to study them well.

Stock options are wasting assets. They have expiration dates. This means you can’t hold them forever. However, they give up to 2 years worth of expiration dates you can use.

Options give you the right but not the obligation to buy or sell a stock at a set price. One contract controls 100 shares. This, in turn, makes trading options less expensive than shares. You’re paying the premium to control 100 shares without paying the market price per share.

Silent Killer

Options theta is the decay of an options contract over time. It’s known as the silent killer because it happens slowly. As a result, a trade can look good on paper. However, the leaching of time is like embezzling from the option.

You may not notice the small amounts taken out daily until too late. Theta options will always be negative for long options and have zero time value at expiration.

Time only moves forward. Hence, time has run out when an options contract reaches its expiration. You can add theta to your options chain if you buy options contracts.

It’ll tell you how much an option declines in price each day. Hence, it is important to pick the right strike price. The strike price is one of the most important aspects of options trading.

The reason for this is the price you believe the option will be at when you’re ready to close the trade. Being in the money or out of the money can greatly affect the theta of an option. To ensure an option will reach your desired price, look at its delta and gamma. Hence, many moving parts affect options trades.

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Options Theta Strike Price

Different strokes trade in, at, or out of the money depending on the stock price currently trading. Out-of-the-money options are usually cheaper because the stock hasn’t reached that price yet.

In the money, options are more expensive because they’re typically at a price the stock has surpassed. Currently, options have the same strike price as the current stock price.

While options theta can seem smooth long term, it slopes more as the price nears expiration. This affects in and out of the money more than at the money strike prices.

That is because extrinsic value is low and in and out of the money options. The probability of those options reaching their intended stock price is much lower.

At the moment, strikes will usually hit their intended price target. However, theta must be discounted over a short period if they don’t.

Options Theta Example

Hour Glass

Think of theta as an hourglass. While deciding when to exercise your option, time, also known as theta, flows into the seller’s side of the hourglass. In essence, the seller is receiving the value of time.

With that in mind, you could write and sell options to take advantage of the 80% of options expiring worthless. For the buyer, the loss of time value may need to be dramatic enough to notice.

However, it is continuous because time never stops moving. If you’re the buyer, spend as much time as possible on the contract. Hence, it is important to pick the right strike price.

When you’re bullish, you aim to have the stock trading at or more than the strike you bought. If you’re bearish and bought a put, then the price should be below the strike you bought at. If that happens before expiration and you hit your profit target, you can close out and not give all your theta to the seller. 

Other Factors

Options Theta can’t be looked at alone when considering options. Other options and trading strategies, such as implied volatility, are important. This is because theta assumes implied volatility and price movement will be constant.

Implied volatility implies the volatility that will take place. It can go for or against you. With that in mind, make sure you’re trading the patterns.

However, that doesn’t mean you’ll make the perfect trade every time. Even making the best trade can take a loss. Remember to plan a trade, then trade that plan.

While theta may be taking an amount from your profit every day, other factors will influence the price of a stock. Don’t ignore that. 

How to Deflect Theta Decay

One thing that a trader can do to deflect that Theta Decay is to trade options spread. Consider the picture below, where the Theta column is in the options chain. Highlighted in green is the 532 call, and highlighted in red is the 533 call. Both have a $0.14 theta. If we buy the call, we will pay 0.14¢ Theta per day, but if we also sell the 533 call, then we are collecting 0.14¢ Theta per day as well; this will “shunt” or deflect that Theta decay and allow the trade to live or die based on other metrics.

Notice that in the example below – we are still looking at options 32 days from expiration. As time passes and we get closer to expiration, the balance between the Theta of the two strikes will likely not remain neutral. So, eventually, this trade would begin to pay out Theta at a higher rate than it collects.

Deflection Examples

Options Theta Decay

We can also do this on the put side by trading a put debit spread (buying to open a spread for a debit) versus opening a put credit, which we would sell to open. In the picture below – we can see the put debit spread I built for this example; we have the 532 put long and the 531 put short.

The Theta on each of these strikes is $0.08, so while we are paying the Theta on the long put, we also collect the Theta on the short put. This “balances out” the Theta impact until enough time goes by to imbalance things. Let’s see one more picture – closer to expiration – to show how things in Theta decay will eventually become unbalanced.

Options Theta SPY

Looking at the picture below – we are in the last week of the options life, and the Theta is much greater! This option has 2 DTE (days to expiration). In the picture above – we were 32 DTE, and the Theta was 0.08¢ puts, but now things are coming down to the end, and the Theta is elevated to crush these options.

Breaking Even Example

Managing Options Theta

Theta is an important aspect of options trading, but it can be managed; also, consider that once a trade is above the break-even (BE), we can sit in a long options trade and get paid to wait. Let’s look at the risk graph to see this.

In the picture below, I have a call debit spread bought at 0.20¢, which is profitable but is still almost a month before it expires. The purple line reflects the current profit of the trade, and the cyan line represents the max profit (to the right of the BE) and the max loss (to the left of the BE).

Each day that price stays above the BE, this debit spread will be paid to wait. This is shocking – I know! But – this is one of the overlooked pieces of options trading that many fail to grasp. It’s not exactly “Theta” – in the general sense – but it IS very much getting paid to wait.

As each day passes – the purple line will slowly move until it is the same shape as the cyan line. If the price is above the BE, we will gain more and more profit (until we hit max profit); if we are below the BE, then we will lose more and more profit until the trade hits max loss.

Options Theta Vertical Spreads

Final Thoughts: Options Theta

Options Theta represents the loss of value on an option daily. If you’re trading options, you must understand how theta will affect your contracts, especially as time expires. Knowing what option theta is all about will have you trading options more successfully in the long run!

If you need more help, take our options trading course.

Frequently Asked Questions

Each option contract is assigned a theta number. This is the amount per $1 move the contract will lose value with each passing day. Eighty percent of options expire worthless. So that means options theta is good for sellers and bad for buyers.

At the money (ATM) options have the highest theta. The furthest out of the money has the lowest theta.

Options theta is positive for short options because time decay is positive for an options seller. It's negative for an options buyer.

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