How Options Theta Works

  • August 23, 2018

Watch our video on how options theta affects options pricing.

What is Options Theta and How Is It Calculated?

  1. Here's what options theta is and how it's calculated:
  2. Measures the sensitivity of the decline in extrinsic value with time passage.
  3. AKA time decay.
  4. Each contract is assigned a theta value.
  5. This is the number that is lost per day in the contracts value.
  6. Each day that passes the contract loses value to an options buyer.
  7. Time decay benefits options buyers.

O.T. is an important factor when purchasing an options contract. Options are decaying assets and theta plays a key role with options losing time value. The video above explains the importance of theta and how to make time decay work in your favor when trading options. 

O.T. is apart of the Greeks in options trading. Theta deals in time decay. 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 do give up to 2 years worth of expiration dates you can take advantage of.

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 current market price per share.

1. Basics

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 being taken out each day until it's 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. If you're buying options contracts you can add theta to your options chain.

It'll tell you how much an option declines in price each day. Hence the importance of picking the right strike price. The strike price is one of the most important aspects of options trading.

The reason for this is it's 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 make sure an option is going to reach the price you need it to, take a look at its delta and gamma. Hence the many moving parts that affect options trades.
options theta

2. Why the Strike Price Is Key With Options Theta

Different strikes trade in, at or out of the money depending on what the stock price is currently trading at. 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 that the stock has surpassed. At the money options have the same strike price as the current stock price.

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

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

At the money strikes are usually going to hit their intended price target. However, if they don't then theta has to be discounted over a short period of time.

How Does Theta Affect Option Price?

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

Think of it as an hourglass. While you are deciding when to exercise your option, time, also known as theta, is flowing into the sellers 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 not be dramatic enough to notice.

However, it is continuous because time never stops moving. If you're the buyer, give yourself a lot of time on the contract if possible. Hence the importance of picking the right strike price.

Your goal is to have the stock trading at or more than the strike you bought at if you're bullish. If you're bearish and bought a put, then price should be below the strike you bought at.

If that happens before expiration and you've hit your profit target, then you can close out and not give all your theta to the seller. We trade options live each week on our live streams (check out our stock market basics page).
options theta

1. Options Theta Other Factors

Options Theta can't be looked at alone when considering options. Other options trading strategies like implied volatility are important. The reason for this is that theta assumes implied volatility and price movement will be constant.

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

That doesn't mean you'll make the perfect trade every time however. 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 are going to influence the price of a stock. Don't ignore that. Take our options trading course.

The Bottom Line

Theta is the representation of time decay on an option on a daily basis. If you're trading options you need to understand how theta is going to affect your contracts. Especially as time gets closer to expiration. 

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