Options Theta

Options Theta Explained

7 min read

Options theta is one of the options for Greeks. Theta measures the sensitivity of the decline in extrinsic value with time. It is also known as time decay. 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. The video above explains the importance of theta and how to make time decay work in your favor when trading options.

Options Theta is a part of the Greeks‘ options trading. Theta deals with 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 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.

Options Theta Example

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.

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Options Theta 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 trading strategies like 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. 

Final Thoughts

Options Theta is the representation of time decay 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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