Option Greeks: THETA

Theta is a measure of the rate of decline of option’s time-value resulting from the passage of time (time decay).
Theta provides an estimate of the dollar amount that an option price will lose each day due to the passage of time and there is no move in either the stock price or volatility.

Theta and the position in the market:
• Long calls and long puts always have negative theta.
• Short calls and short puts always have positive theta.
• Stock has zero theta – its value is not eroded by time.

Positive theta means that the option value will increase as the time passes, while negative theta means the option value will fall as the time passes.

Therefore, it makes sense that long options have negative theta and short options have positive theta. If options are continuously losing their time value as days pass, a long option position will lose money because of theta, whereas a short option position will make money because of theta.

But theta does not reduce an option’s value in an even rate. Theta has much more impact on an option that is nearing expiration than an option that is still far away from expiration.
The further is an option from its expiration date, the smaller the time decay (theta) will be for the option.
This implies that if you want to buy options (Calls or Puts), it is advantageous to buy longer term contracts to minimize the time decay effect.
However, if you want a strategy to take advantage of time decay, then you should sell the shorter term options, so that the loss in time value would happen quickly.

Example:
The price of ABC May 50 Call with 25 days to expiration is $3. Its theta is -0.10. The price of ABC Jul 50 Call with 85 days to expiration is $4.8, and the theta is -0.03. When one day passes and there is no change in ABC stock price as well as the implied volatility of either options, the value of ABC May 50 Call will decrease by $0.10 to $2.9, and the value of ABC Jul 50 Call will drop by $0.03 to $4.77.

Theta of ATM, ITM & OTM Option
Theta is typically highest for ATM options, and is progressively lower as options are ITM and OTM.
This makes sense because ATM options have the highest time value component, so they have more time value to lose over time than an ITM or OTM option.

The Effect of Time Remaining to Expiration on Theta

For ATM option, Theta increases as an option get closer to the expiration date.

In contrast, for ITM & OTM options, Theta decreases as an option is approaching expiration. The above effects are particularly observed in the last few weeks (about 30 days) before expiration.

The Impact of Implied Volatility (IV) on Theta
When Implied Volatility (IV) decreases, Theta will be lower, especially when it is approaching expiration.
On the other hand, when IV increases, Theta would be higher.

Comparing more volatile stocks (higher volatility stocks) vs. less volatile stocks (lower volatility stocks), the theta of more volatile stocks is higher than that of less volatile stocks. This is because the time value portion of more volatile stocks is higher, and therefore they have more to lose per day as time passes.

To read about other Option Greek, go to: Option Greeks.

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* More Understanding about Options Time Value
* OPTION PRICING: How Is Option Priced?
* Difference Between Option’s Volume and Open Interest
* Understanding Implied Volatility (IV)
* Options Trading Basic – Part 2
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