Do You Have Time for Theta?

Of all the option greeks, option theta may be the easiest to comprehend. That being said, truly understanding how it works is another story. Let’s take a quick look at the definition of theta and how it may change your thought process when it comes to 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 the amount of theta. All options both long and short decay due to time. Long options, both calls and puts, 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, it decreases the premium. That is why theta is considered to be negative for long options. 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 bought back at a lower amount or if it expires worthless.

Multiple Legs

But what if there are multiple legs on your option trade? If your positive theta is bigger than all the negative theta, time passing helps the position whether it be a debit or credit spread. If your negative theta is bigger than all the positive theta, 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, 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. Knowing how to read your option position, and especially theta, can help you manage trades more efficiently.

John Kmiecik, Market Taker Mentoring

Trader Education