Are You Making Time for Theta?

When most people think about buying equity options, they think of time and expiration. Of course, options are expiring assets. Of all the option greeks, theta may be the easiest to comprehend on the surface. But truly understanding how it works is another story. Let’s take a look at the definition of option theta and how it may change your thought process when it comes to implementing and managing trades.

Option Theta

Theta measures the rate of decline in the value of an option due to time passing. Keeping it simple, for every day that passes, theta should decrease the option’s premium by its amount. All options lose value due to time. Long options, both calls and puts, are said to have negative theta. Short options, both calls and puts, have positive theta. How can we use this as part of our option trading?

Time passing will always decrease option premium keeping all other variables constant. Long options have negative theta because as time passes, premium decreases. That is why theta is considered negative for long options. Option premium decreases, which is not beneficial when trying to sell for a higher price.

Short options have positive theta because premium is decreasing and that is beneficial for a short position. A profit is made if premium is sold and then bought back at a lower amount. In addition, out-of-the-money (OTM) options expire worthless at expiration. The original premium collected at the initial sale is then realized by the option seller.

Multiple Legs

Long calls and puts are the only two option positions that can never produce positive theta. Theta becomes a tad more complicated when both long and short options are involved, but there is an easy way to think about it. If your positive theta is bigger than all the negative theta for the position, time passing helps the position whether it be a debit or credit spread. If your negative theta is bigger than all the positive theta for the position, time passing hurts the position for either a debit or credit spread. Keep in mind that this can change throughout the life of the trade too.

Theta Is Greatest ATM

Just like gamma and vega, theta is highest at-the-money (ATM) and smaller in-the-money (ITM) and out-of-the-money (OTM). That is why theta can change between positive or negative for many spread trades because it depends if the underlying is trading closer to the long or short option. Theta also gets smaller further out to expiration, so a longer expiration means a smaller theta number.

Last Word on Theta

Theta is one of those greeks that may be easy to understand on paper but a little confusing when it comes to whether it is hurting or helping the position, particularly when spreads are concerned. I like to tell option traders that if you fast forward position to expiration and you will make money, you currently have positive theta. If not, you currently have negative theta. Knowing how to read your option position, and especially theta, can help you manage trades more efficiently.

John Kmiecik, Market Taker Mentoring

Trader Education