Options have two sources of value: intrinsic value and time value. From the moment an options contract is created, the time value component decays. This rate of change in value with respect to time is known as theta.
Understanding theta is crucial if you are going to trade options. Several factors, including an option’s moneyness and the time to expiration, will impact theta. Here are the basic concepts that you should know about.
How Does Theta Work?
Holding all other factors equal, options tend to decline in value over time as they approach their expiration date. The intuition behind this relationship is simple: once an option expires, it can no longer be exercised, and thus it no longer has any value. This rate of change in value of an option is referred to as theta. Usually displayed as a negative dollar amount, an option’s theta value represents how much an option’s price decreases per day as it matures.
💡 Interested in Theta? Check out the other Greeks in options trading.
What Are Examples of Theta?
One way to think of theta in options trading is an analogy of an ice cube sitting on a countertop. As the ice cube sits on the warm countertop, it gradually melts away, and the melting becomes more rapid as time passes. Similarly, an option’s time value always decreases, with the decrease becoming more rapid the closer an option is to expiring.
Let’s say there is a stock ABC with a price of $80. The theta for an options contract expiring in three months with a strike price of $85 might be -$0.05. That means you can expect to lose five cents per day due to time decay, or theta. That doesn’t necessarily mean that the security’s price will go down each day, since it will also be affected by up and down movements of the underlying stock price itself.
In this scenario, not all options of stock ABC will have the same theta value of -$0.05. An option with the same strike price of $85 but a year until expiration will usually have a lower theta than one expiring next month.
What Is a Negative Theta in Options?
Because theta represents the amount of money an option contact loses every day, it is customarily represented as a negative number. A theta value of -$0.15 for a particular option means that particular option will lose 15 cents of time value each day.
But because the time value loss of an option (theta) isn’t linear, you shouldn’t expect it to lose exactly 15 cents of time value every day. Theta will increase as the option expiration date gets closer. This is very important to know if you’re attempting to time the market, since it will help you understand when the best time is to make your move.
Understanding Options Theta Decay
There are many different strategies for trading options, and theta affects them differently. Since theta is a negative number, it works against buyers of options. But if you are selling an option (like in a covered call or other option strategy), theta works in your favor.
When you are selling an option contract, you are hoping that the option will decrease in value or expire worthless. So a high theta value works for an option seller since it represents the amount of money the contract will lose each day.
Calculating Theta
Calculating theta, or any of the other Greeks, requires using advanced mathematical formulas, and depends on the particular pricing model you choose. Options investors typically calculate theta on a daily or weekly basis.
Generally theta will be smaller for options that are far away from their expiration date and larger as you get closer to expiration. You can use this knowledge to determine your best plan depending on your time horizon for investing.
The Takeaway
Whether you’re trading basic options or more complicated options spreads, it is important to understand theta. It represents how much value your option will lose as time moves closer to its maturity, holding other factors constant. One needs to be especially careful to take note of theta when trading out-of-the-money options.
Trading options is an advanced way to invest in the stock market. SoFi offers an options trading platform with an intuitive, user-friendly design. Investors are able to trade options either on the web platform or the mobile app. The supporting educational resources about options can also be helpful as you’re getting started.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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