Let’s talk Greeks—and no, there will be no reference to toga parties (sorry about the clickbait). Instead, the “Greek” we’ll cover is theta, aka time decay. Theta describes the declining value of an option as time passes, a critical component for anyone trading options.
Specifically, theta reports how much an option theoretically decreases in value with the passing of each day.
For example, if you purchase a call option for $5 and the theta of the option is $0.50, then the option will theoretically lose $0.50 of value for each day that passes. After two days, assuming no movement in the underlying, the option will be worth $4.
The concept of time decay perfectly frames the ongoing struggle between option buyers and option sellers. Option sellers hope that movement in the underlying remains muted, with the goal of keeping as much of that theta as possible through expiration.
On the other hand, option buyers are typically cheering for a big move in the underlying—or, at the very least, an increase in implied volatility—which in turn could theoretically boost the value of their long position.
When trading a portfolio with multiple options positions, traders must also manage theta decay at the portfolio level. Strategically, this might involve targeting an absolute level of daily net theta (whether collecting or paying) that matches one’s outlook and strategic approach.
For example, a portfolio might have five long options and five short options, but the overall theta may be positive (meaning it is net collecting theta). No matter one’s exact approach, it’s important to monitor and manage the portfolio’s aggregate theta, as opposed to only watching theta at the position level.
As a reminder, the value of an option can be broken down into both “intrinsic” and “extrinsic” value. Options with intrinsic value are always in-the-money (ITM) because intrinsic value is equal to the difference between the current value of the underlying and the strike price of the option.
For example, imagine that stock XYZ is trading $50, and the $45 strike call is trading for $6. The difference between the underlying price and the strike price ($50-$45 = $5) equals the intrinsic value of the option, which is $5. The remaining portion of the option’s value ($6-$5 = $1) is referred to as extrinsic value.
Intrinsic and extrinsic value are important when discussing theta because it’s the extrinsic value of an option that is affected by the passage of time. Whereas the intrinsic value, or parity value, of an option is dictated by the price of the underlying and the strike price—not time.
Based on the above, one can see why at-the-money (ATM) options generally possess higher theta numbers (all else being equal) because there exists greater extrinsic value in ATM options. This makes sense because ATM options are more “in-play” as compared to options that are deep in-the-money (ITM) or far out-of-the-money (OTM).
One final point to keep in mind is that as expiration gets closer, the rate of theta decay speeds up. All else being equal, the steepest theta decay generally occurs with five to seven days remaining until expiration. While this may increase our theta-per-day collections, one mustn’t forget the double-edged sword of risk and reward.
With additional potential reward (higher theta per day) also comes additional potential risk. As short premium positions approach expiration, exposure to potential big moves in the underlying can intensify. For example, If a big move does occur near expiration, there’s very little—or no—time left for a tested position to recover.
The above highlights why theta and time decay are so critical to any options trading endeavor. Decisions related to buying and selling premium, as well as the length of time a position is held, can all be tied back to balancing risks and rewards related to time decay.
Traders seeking to learn more about time decay and theta may want to review a recent installment of Best Practices presented by the tastytrade financial network. This particular episode highlights some of the most important elements of theta decay, as well as some helpful examples that can help reinforce these concepts.To learn more about optimizing days-to-expiration (DTE) in short premium positions, traders can also review “The Magic of 45: Optimal Short Options Trade Duration.”
Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about topics covered in this blog post, or any other trading-related subject, to firstname.lastname@example.org.