Here’s the story of an innocent trader who knew not of the subtle but powerful effects of time. The trader was holding a few long Tesla (TSLA) calls, monitoring the value of the position throughout the day, happy with the direction it was going.
A week or so goes by and the trader starts to notice the position is mysteriously losing value, and notably, more and more as time went on. By the time it was only a few days before expiration, the investor had watched in horror as their position’s value completely evaporated.
“Why did this happen?!”, the trader thought, feeling panicked and confused. The underlying value didn’t fall, it went up! Nothing else changed, so why did the value of the position disappear?
What the trader was not aware of was a witch in the forest of the stock market named “time decay”. When the position was born, it was cursed by the theta witch, poisoning it from its birth, creating an irreversible fate: the effect of time decay.
Time decay is the effect of time on an option’s value, also known as its premium – and theta is the measurement, represented as a value, of the effect of time decay.
What Exactly is Theta?
First, what exactly are options? Options are derivatives of assets & securities in the form of contracts that allow you to either buy or sell (depending on the type of option you have) 100 shares of the security the option/ contract is associated with at a set price, over a set period of time.
There are two categories of options contracts: calls, which give you the right to buy; and puts, which give you the right to sell. The price of an option contract is known as its premium.
You can see in the image below that the closer the option is to its expiration date, the more magnified the effects of time decay become.
How Traders Calculate Theta
Calculating theta is pretty straight-forward. Theta is initially calculated in years, using this equation:
Theta = (-) Premium/ Time
Premium = Cost or price of an option contract
Time = How many days are left until expiration
Say we want to find the theta of a Ford (F) call that expires in 2 weeks (14 days). Let’s imagine the premium is $73.00 (100 shares *0.73).
Theta = (-) 73 / 14
Theta = -15.21
Now that we have theta calculated in years, we can calculate for theta in days so that the value is more useful for us, as we’ll be able to see what the theoretical decline in price will be per day instead of per year.
To do this we just need to divide the theta value in years by the number of trading days in one year, which is 252:
-5.21 / 252 = -0.0206
Now we have a more usable form of the theta value. So this means that for every day that passes, the premium of the option will lose, in theory, $-0.0206.
What About Theta (Time) Decay?
Theta and time decay are related, but not synonymous. Where time decay is the depreciation of an option’s premium due to the passage of time, theta is the value that represents how exactly time is predicted to affect the option’s premium. This distinction is important because it separates the ideas of an option’s premium decaying, but also theta itself decaying.
What this means is, the passage of time affects an options premium and theta simultaneously, but depending on different factors theta is affected differently. The two key factors are the time before expiration and how close, or far, an option is from being at-the-money.
We’ll dive into a more specific example later one, but for now, the basic concepts are:
- ATM options: theta is affected more than ITM and OTM options, specifically, it will continue to increase, especially as expiration nears.
- OTM options: theta will also increase as expiration nears, but it is affected much less than ATM options.
- Deep OTM options: theta decay moves more linearly than exponentially with ATM options, and will settle more as expiration nears.
Using Theta When Trading Options
Using theta when trading options can be quite helpful, but it’s important to understand all of the different factors that play a role in creating the value of theta so you know how to use it properly. Whether a contract is ITM, OTM, or ATM, for example, will greatly affect theta’s value.
We’re going to get into some in-depth examples of different strategies used to trade options, and see how the value of theta is affected in the different scenarios, and how this would affect an investor’s ability to profit.
We’ll start with a more basic example of a single position, and progress toward positions that have multiple components.
The first strategy we’ll look at is the most simple: a single-leg position. A single-leg position is simply if you long a call or a put, or if you short a call or put.
Two factors make up the value of theta, and that’s time and the options premium. We’ve discussed the first, being the effect of time decay, or the passage of time – and how that effect becomes more magnified as expiration approaches, thus exponentially increasing the theta value over time.
The other factor is the option’s premium. The way options are valued and how option premiums change is a complex topic outside the scope of this article; for now, we’ll keep it simple and just look at some examples of how different strike prices affect the premium, and thus the theta value. The strike price determines if an option is in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM).
We’ll use Target (TGT) to highlight some examples of varying thetas. We’ll look at the theta values of an ITM and OTM TGT call with 90 days left until expiration, 60 days, and 30 days (six different contracts in total). The calls will be $10 in the money or $10 out of the money.
With this raw data to look at, let’s see how it represents what we’ve discussed so far. The first concept we talked about was the exponential increase in the effect of time decay. You’ll notice that the difference between the 90 and 60-day calls is much less than the difference in theta values between 60 and 30 days left until expiration.
More specifically, the difference in theta values between the ITM calls with 90 and 60 days left is 12.10%, and the difference between the ITM calls with 60 and 30 days left is 60%. This clearly shows the compounding effect of time.
Next, we talked about how different strike prices will create different theta values. We can see that the OTM calls have lower theta values than the ITM calls. Notably, we can also see that the difference between the theta values of an ITM and an OTM call with 90 days left until expiration are closer in value than the ITM and OTM call with 30 days left.
So even with just a single-leg position there are a lot of moving parts, more than many people have the time to pay attention to. To save time and energy, many investors subscribe to alerts from experienced options traders so that they don’t have to spend each and every day monitoring the markets. Instead, their attention can be dedicated to other life pursuits such as their career or family, and they’ll still be notified of potentially profitable options positions.
Credit and Debit Spread Theta
Next, we’ll look at some more complex positions: credit and debit spreads. Spreads are another options strategy that involve more than one option and seek to capture profit differently than single-leg positions. Credit and debit spreads are also affected quite differently than single-leg positions. Let’s jump into some examples to highlight these ideas.
The first spread we’ll look at is referred to as a put credit spread. We’ll use Disney (DIS). To set up the play, first, we’ll sell a DIS put with a higher strike price and then buy a DIS put with a lower strike price. Both contracts will have the same expiration dates. Because the put you sold has a higher strike price, it will have a higher premium. This means that as a result of the two trades, you will end up with a net credit via the premium you received by selling the contract.
But how does theta factor into this whole equation? With contracts you sell (aka short or write), negative theta will benefit you because if you sell a position, to close it you have to buy it back, so it’d be more conducive for you to buy it back after theta has chewed into it.
Therefore, in this example, you profited because of the passage of time. This is one of the unique aspects of options, capturing profit in almost any market condition, even if the underlying price hardly moves, and time decay is eating positions away, you can still end in the green.
The Iron Condor
So far we have looked at how theta values affect a single-position and a position with two options. Now we’ll look at a strategy involving four options: the iron condor. An iron condor is a rather advanced options strategy, and demands a lot of attention and care.
Iron condors are built from two spreads that have different strike prices. The expiration dates are kept the same for both spreads. An iron condor can be thought of like a strangle, where strangles are two options with different strikes and the same expiration date, iron condors are used in similar situations, the difference is that they’re built from two spreads, not two options.
These images can be kind of confusing so let’s break it down. We have our four options listed at the bottom of the graph in blue, moving from left to right as the strike prices increase. The further out you go from the middle, the further out of the money you go, and the further out of the money an option is, the less it’s affected by theta as time progresses.
This means that, if all other factors are held constant, an iron condor reaps a large benefit from the passage of time because the long positions are affected less than the short ones, and the short ones are the ones that benefit from the passage of time.
The key to trading options effectively is to understand how they’re priced, and the Greeks are tools used to measure and assess the different factors that affect just that. This makes theta a very handy tool in understanding options and trading them effectively. Time decay is the bane of many options traders, but if you can understand the ins and outs of theta, you can use it to your advantage.
Like when you short options, the passage of time is benefitting you. But then you expose yourself to the risk of a short position, so maybe you decide to hedge it with a long position. If you choose to do this, it’d be in your best interest to choose an option that is further out of the money because it’ll be affected less as the expiration date gets closer.
This is an example of why it can be helpful to use theta and understand time decay. If you don’t, you might not be aware of why a position starts losing value seemingly out of thin air, not knowing you have a ‘theta leak’. Understanding theta and time decay will help you take advantage of it instead of it taking advantage of you.
Understanding Theta in Options Trading: FAQs
What is ‘Absolute Value’ in Theta?
Theta values are affected in different ways, and are not all the same. The absolute value of theta increases more with options that are closer to the ATM value. With out-of-the-money contracts, theta value decreases because they are less likely to be above or below the strike price. And lastly, contracts deeper in the money will lose value over time.
What’s a Good Theta in Options Trading?
A ‘good’ theta in options trading is entirely circumstantial. Perhaps the baseline for what a good theta is, is whatever the breakeven point is. Namely, what does theta have to be for a position to break even, and anything above that value can then be considered “good”. Essentially, a ‘good’ theta is one that still allows you to profit in the end.
Can Theta Help with Short Options?
Theta can help with short options because in the case of short options, the seller benefits from time decay. Whereas with long options you want to buy low, sell high, with short options it’s the opposite. So if you sold a contract and you want to close it, you have to buy it back. If the value of theta was increasing, when you go to buy it back to close the position you’ll end up buying it back for less than you sold it for, so you’ll profit in that case, thus theta can help with short options.
What’s the Difference Between Positive and Negative Theta?
It is extremely rare to have a positive theta, so the vast majority of the time theta values will be negative. This is because theta is a measurement of risk, specifically the predicted amount that an option’s premium will fall.
Notably, however, you can have a net positive theta. Meaning if you sell an option and long an option, and the total theta is positive, you have a net positive theta. There are very rare cases where theta can be positive
How Fast Does Theta Decay?
Theta values change as options approach their expiration dates. Initially the change is slow, but increases in speed exponentially as time progresses. The chief principle with time decay/ theta value is, the closer to expiration, the more of an effect time decay/ theta will have on an option’s premium, the further out the expiration is, the slower the decay will be.