What Do You Know About Option Theta?

What do you know about option theta? For many, it can be the easiest option greek to understand, but for many others it is the most difficult. Let’s take a quick look below and, let’s hope, clear up some confusion.

Theta Definition

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. 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? Theta is also highest at-the-money (ATM) and smaller out-of-the-money (OTM) and in-the-money (ITM).

Keeping It Simple

Time passing decreases option premium, keeping all other variables constant. Long options have negative theta, so time passing will decrease the premium. To make a profit on a long option, it needs to be sold for more than it was purchased. 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 it expires worthless. It sounds simple and it really is. If you remember the above, you will have a solid grasp of theta.

Multiple Thetas

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.

Don’t Complicate Things

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 where spreads are concerned. Remembering positive and negative and whether it is a debit or credit position will make it easier to understand.

John Kmiecik, Market Taker Mentoring

Trader Education