Information on Options Theta
Options Theta is one of the important options Greeks that can be used to help you predict how the prices of options change in relation to various factors. The theta value is the Greek which indicates how the price of an option changes as the expiration date gets closer and closer.
The extrinsic value of an options contract will diminish over time as the expiration date of that contract approaches, due to the effects of time decay, and Theta is basically an estimated measurement of the rate at which this happens. In theory, theta value will tell you how much the price of an option will depreciate on a daily basis. On this page we provide details on the characteristics of this Greek and explain how you can use it.
Characteristics of Theta
The theta value of an option essentially shows the dollar amount at which the price of an option will fall each day, assuming all other factors remain equal. An option with a theta value of -.01, for example, would lose $.01 from its price each day due to time decay. One with a theta value of -.005 would lose half a cent from its price each day.
Calls and puts both have negative theta values, because they both lose extrinsic value over time due to time decay. It's worth noting, though, that if you write options to take up a short position on them, then theta will work in your favor. When you own options contracts, time decay has a negative impact on the value of the contracts that you own, but when you are short on options the effect of time decay is a positive impact.
There are two main factors which influence theta value: moneyness and the length of time until expiration. The theta value is usually at its highest point when an option is at the money, or very near the money. As the underlying security moves further away from the strike price, meaning the option is going into the money or out of the money, the theta value gets lower.
A deep in the money option would have less extrinsic value to diminish, because the price would be made up of mostly intrinsic value, so the rate of decay tends to be slower. A deep out of the money option would also have less extrinsic value, but for a different reason. The further out of the money it is, the less chance there is of it finishing in the money.
The length of time until expiration also impacts the theta value, as the effect of time decay typically increases as an option gets nearer to expiration. Theta value will usually get higher the less time there is until expiration, although the exception to this is for deep out of the money options.
As mentioned above, deep out of the money options usually have very little extrinsic value, and by the time expiration gets close there's such a small amount left to decay that the theta value will probably get lower and lower. It's also worth noting that the theta value of an option is usually in direct proportion to the gamma value of that option.
Putting Theta to Use
Theta is particularly important for traders when they are using trading strategies for a neutral market, because those strategies are usually used specifically to make a profit out of the effects of time decay.
When using these types of strategies, it's essential that the overall theta value of your position is at the appropriate value so that you can benefit from the diminishing extrinsic value. If your position is going to be negatively affected by time decay, then you will be relying on directional moves in the underlying security in order to make a profit: which hinders strategies the point of using those strategies in the first place..
Traders that are using strategies to profit from significant directional moves in underlying securities, and/or are planning to hold positions all the way through to expiration, don't need to worry too much about theta. The loss of extrinsic value in these trades is essentially a direct expense of making the trade, and should be offset by profits made from the relevant directional moves.
Delta is far more relevant in these instances, although of course, there's nothing to be lost by checking the theta values involved and gaining an idea of what the effects of time decay are likely to be.
Theta is very relevant to traders when they are entering positions where they are expecting small directional movements in underlying securities over a relatively short period time. In order to make a profit from entering these positions, the gain in intrinsic value needs to be greater than the loss of any extrinsic value.
Ideally, if you are speculating on small movements you want to be trading options that have low theta values so that the effect of time decay doesn't wipe out any profits that you make from those small movements. This is why an understanding of this value and what it means is so important.