Theta is used to calculate how much an options contract premium is affected each day as the contract nears its expiration date. Time to expiration is one of the most important determining factors of which options contract an investor purchases because it affects the value of the options contract.
So what is Theta, when should you use it, and what are some examples of Theta in action? Here is everything you need to know about using Theta for trading options.
Definition and Examples of Theta
Theta measures the rate at which an options premium changes per day as it approaches its expiration date. In other words, the Theta value tells you the rate of time decay as the contract gets closer to expiring. Investors use Theta as a way to manage market risk when trading options because it helps them understand how time decay will affect the price of an options contract.
You can typically find the theta value of an option among the data and tools your brokerage provides in your account.
If you are selling options contracts, Theta is a good thing because the more time passes, the more the option decreases in value, and therefore the chances of the buyer taking any actions also decrease. Because of this, a higher Theta is preferred when selling options.
How Theta Works
Because options lose value as they approach their expiration date, Theta is usually stated as a negative number. So, if the Theta measurement is -0.40, the options contract will decrease by approximately $0.40 per day. Because options contracts generally give the investor the right to buy or sell 100 shares of the underlying asset, one could assume that a $0.40 decline per day would equal approximately a $40 decrease per day ($0.40 x 100 = $40).
Theta is usually negative for bought calls and puts but positive for sold calls and puts.
For example, let’s say you’re comparing two options contracts for XYZ company. You’re looking for the optimal time to purchase options on XYZ company and prefer to buy an option with a value that decreases at a slower rate as it approaches expiration.
The first option has a Theta of 0.25, and the second has a Theta of 0.35. Because the first option has a lower Theta, you know that the value of the contract will likely decrease at a slower rate as it approaches expiration.
Keep in mind, though, that time-value erosion is not a linear measurement. This means that as time goes on, the higher the rate at which an options Theta increases and the more money the option loses each day due to time decay.
Generally speaking, Theta on options that are in-the-money (ITM), at-the-money (ATM), or slightly out-of-the-money (OTM) increases as they approach their expiration date. However, Theta for options that are very far out of the money generally decreases as they approach expiration.
Theta is a measurement of the theoretical risk of an options price sensitivity to time decay, not a reliable measurement of an options contract’s value. Also, Theta assumes that changes in price and implied volatility are continual, which means an options contract’s Theta may change from one day to the next accordingly.
Alternatives to Theta
Alternative options to Theta include analyzing options contracts with any of the other four Greek measurements including Delta, Gamma, Vega, and Rho.
- Delta: Measures the price change of an options contract as the price of the underlying asset changes.
- Gamma: Rate of change that an option would experience based on a change in the underlying asset’s price.
- Vega: Measures the price sensitivity of an options contract as the implied volatility of the underlying asset changes.
- Rho: Measures an options price sensitivity to a change in interest rates.
These Greek measurements are all related to measuring the risk of an options contract. Your ultimate objective for each option purchase will determine which Greek measurements to use in determining the best investment for your portfolio.
What It Means for Individual Investors
Perhaps one of the most significant differences between investing in equities and investing in options is the fact that options have an expiration date. Thus, time is of the essence and can dramatically affect your profit or loss. Understanding an options Theta means you can better manage the time decay of an option as it approaches its expiration date and adjust your strategy accordingly.
- Theta is the measurement of time decay. It measures how much an option’s premium is affected as the expiration date nears.
- Theta, like other measurements signified by a Greek letter, is used to manage and assess certain risks of an options contract.
- Theta is a derivative of an option assuming ongoing changes in implied volatility and price of the underlying stock. As a result, Theta will vary from day to day.
- Theta is a theoretical measurement assuming all other inputs affecting the options price stay the same.
- Understanding how to use Theta as an investor will help you better manage the time decay of each options contract you purchase.