Complete Guide to Theta Options

Did you know that some assets lose value as time passes?

Let’s say you bought a car – a brand new Mercedes Benz. And let’s say that you drive it only occasionally, mainly because you like your Porsche more. After five years, it’s time to sell the Benz and treat yourself with something different, maybe a new hot-air balloon. 🎈

The value of that Benz isn’t much lower than when you bought it since you didn’t drive it a lot, right? Wrong. Even if you didn’t drive it a lot, the value of the Benz decreased solely because of one reason – the passage of time. As time passes, the value of assets such as vehicles drops, which can come as a surprise for you as an owner.

A similar concept can be applied to options contracts as well – but with one key difference. While the Benz doesn’t have an expiration date (if it doesn’t break down, hypothetically, you could drive it forever), options do have an expiration date, and the closer they are to it – the more their price will decrease.

Because of this, many traders find it hard to shift from stocks (which you can hold forever) to options trading. Nithin Kamath, CEO of Zerodha, one of the biggest Indian brokerage firms, says that 80% of all open buy option positions end up as losses at the end of every day – far more than in stock trading.

If you want to begin with options trading – it’s crucial to be aware of different indicators that can help you make a profitable decision. “Greeks” are measures considered to be the holy grail of options trading, with theta being one of the most important values. Theta will also be the main subject of this article, and we’ll talk more about what it is and how you can use it.

What is Theta in Options? 🧠

Many factors can influence the price of an option, which can assist or hinder traders depending on their position. The so-called “Greeks” are what the literature usually portrays as a set of risk measures that reflect how sensitive an option is to time-value decay, changes in volatility, or price movement of its fundamental security.

There are a total of four Greeks in options trading: theta, vega, delta, and gamma. We will talk about the latter three later on – but now, let’s focus on theta.

The short answer to the question in the heading above is that theta is simply a measurement of time decay. It represents the rate at which the value of an option decreases over time. The general rule is that the closer an option gets to its expiration date, the less valuable it becomes (if it is far away from its target price).

This decrease that theta brings occurs on a daily basis. For example, if theta number is -1, this means that the option losses $1 of its value each day. In theory, theta can be any number, but in most cases, it’s going to be anywhere between 0 and -1. Everything “above” -1 is considered to be a big theta number as it deducts more of the option’s value.

It is known that factors such as volatility can impact the price of the stock. An excellent example of this is the recent Delta variant of Coronavirus and the increased volatility it brought. With that being said, since all options have an underlying security that they are based on, if the price of that security falls or rises considerably (due to increased volatility or liquidity), the option will change as well – which is important to avoid.

This is why when discussing theta (and other “Greeks”), options analysts commonly use the term “all other things being equal.” This means that volatility and price of the stock are constant measures – and therefore, we can expect that the price of an option will drop as it reaches the expiration date without any external impacts.

How Does Theta Relate to Other Greeks? 🇬🇷

We said that besides theta, three more measures make a total of four “Greeks.” Those are:

• ☑️ Vega 
• ☑️ Delta
• ☑️ Gamma

Each of these measures has a unique way of working and calculates the sensitivity of option prices compared to the specific variables.

The central aspect of theta is the concept of time decay and how an option loses its value over time. However, other “Greeks” don’t deal with the time aspect but rather tackle something completely different.

The delta measurement of an option, for example, illustrates how sensitive an option’s price is to a $1 change in the underlying security. An option’s gamma is the rate of change in its delta for every one-point change in the underlying asset’s price.

Last but not least, each percentage point change in implied volatility is represented by Vega, that shows how an option’s price theoretically fluctuates.

New options trading enthusiasts may find these phrases perplexing and frightening, but when broken down, they relate to simple principles that may help you better grasp the risk and possible return of an option position. Also, it’s important to remember that the figures calculated for each “Greek” are purely theoretical.

How Does Theta Work? 💭

Before we understand how theta works, it’s vital to acknowledge how options work. An option is essentially a contract between two sides – a buyer and a seller. The buyer has the right to purchase or sell an underlying stock at a set price by a specific date under an option contract.

Since options depend mainly on a specific asset’s value, they are considered to be derivatives. The price under which an asset can be sold is called the strike price. When the contract is originally written, the strike price is established – notifying the investor of the price that the asset has to reach before it gets bought or sold (at a profit).

Literature recognizes two types of options: “Calls” and “Puts.” With a call option, the buyer has the right to buy an option at a specific strike price written in the contract. In contrast, put options let the holder sell the underlying asset’s option at a specific predefined strike price.

Calls are purchased on the assumption that the underlying asset’s value will rise above the exercise price (strike price) before option expiration. Put option holders, on the other hand, bet that the underlying asset’s value will fall below the exercise price before expiration.

Due to the fact that options may only be exercised for a limited time, theta is used to quantify the risk that time poses to an option. As time passes, the value of an option deteriorates, a phenomenon known as time decay – and at the same time, the profitability of an option decreases. 

Theta is commonly expressed as a negative number since it indicates the potential risk of time and the decrease in the value of an option. Therefore, for long options, theta is considered to be always negative and those options have zero time value at the moment of expiration. Hence, the longer you keep an open option position, the more likely you are to lose. 

With that being said, it isn’t a surprise that theta is beneficial to sellers, but not to purchasers: the buyer’s worth falls with time, while the seller’s value of an option grows – all because the option will lose its value as time passes. 

For this reason, option sellers gain more money when they sell their options, which is why selling an option is often referred to as making a “positive theta transaction.” 

Generally speaking, short positions are always superior to long positions when looking at theta. Since the value of an option decreases with time, someone who is looking to short is in a more favorable position compared to someone who is going long – because short sellers are “betting” that the option will lose value in the future. 

How Does Time Affect Theta? 🤔

We said that time is the central aspect of theta in its calculation. We also noted that the concept of time decay causes an option to lose its value. But, let’s be more specific. When we say that time decay affects value, it’s essential to distinguish two different parts of that value in option trading. Extrinsic and intrinsic values are like two siblings, and they are connected with a special bond.

In a nutshell, intrinsic value resembles the actual worth of an asset. A rather complicated financial model is used to calculate this metric instead of utilizing the actual market price of an asset, but we won’t cover that here (computers do it automatically for you anyways). On the other hand, the difference between an option’s market price—called the premium —and its intrinsic value is measured by extrinsic value. 

Time decay affects only the extrinsic part of option value as it approaches the expiration date. At the moment of expiration, all that is left is intrinsic value (if any of it remains) and at that moment, options are practically worthless, as seen with $2 billion worth of Bitcoin options that expired in mid-2021. 

Let’s say that you have two very similar options, the only difference is that one will expire later. The option that lasts longer compares theta that is closer to 0 to the short term option.

This is logical, since short term options have an expiration date that is near and thus, they lose more extrinsic value daily. More value to lose equals a larger theta number (on the negative side). When longer options come closer to their expiration date – that’s when their theta is the most negative it will be. 

Picture below shows this nicely – you can see that theta number is higher on the negative scale as the option approaches its expiration date. 

It’s also important to know that theta changes and it doesn’t have to be the same each day. If an option lasts 180 days, the starting theta will probably be very small. However, as the expiration date approaches, that number will surely increase due to the time decay. 

Moneyness of an Option Contract 📜

We mentioned that when the contract is written, the strike price is established. This strike price is important since it’s connected to the “moneyness” of an option contract. We could say that “moneyness” is essentially a classification method – and every option can be classified in one of three categories:

• ☑️ In the money (ITM)
• ☑️ At the money (ATM)
• ☑️ Out of the money (OTM)

This categorization aids the trader in determining which strike to trade in a given market situation. 

To place your option in a category, you first need to calculate its intrinsic value. If the intrinsic value is high enough to give you a profit when you exercise the option, then that option strike falls into the “In the money” category (cashing in the option is profitable). 

If the intrinsic value is too small to give you a profit, the option strike is “Out of the money,” whereas “At the money” refers to the strike that will only let you break even if you exercise your option. 

There are also two more situations worth mentioning:

• ☑️ If the option’s strike is higher than the price of the underlying – ITM.
• ☑️ If the option’s strike is lower than the price of the underlying – OTM.

We’ll leave this categorization for now – but we’ll mention it again in another paragraph since it’s relevant for different theta trading strategies. 

How Does Volatility Affect Theta? 💡

We said that when talking about “Greeks” in general and specifically theta, external factors such as volatility are “taken out of the equation.” This means that for the purpose of calculation, these factors are held constant.

Now, this is obviously applicable in idealistic cases, but things work differently in the real world. It’s important to give proper attention to volatility when discussing theta.

Options of stocks with high volatility usually have higher theta (on the negative side) than stocks with low volatility. The explanation for this is simple – those options have a higher time value premium, which means they naturally have more to lose every day. 

While volatility might not always dictate the theta number, it’s essential to keep in mind that very high and very low volatility should always be considered. After all, volatility plays a significant role in everything stock-related – and “Greeks” are no different.

Options Theta Example 💰

All of this might sound a bit confusing – especially if you’re new to options trading. But, we are here to explain complex things to you in a straightforward manner, and giving an example is perfect for that purpose. All you need is a little bit of imagination. It won’t be that hard. 👌

Imagine that you’re an investor and want to buy an option for a specific underlying stock. You think that it’s a good time for investment, so you purchase an option that has a strike price of $2,000 for $10. 

This means that you didn’t really buy a stock – you bought an option for that specific stock. Let’s also assume that that same underlying stock is trading at $1950 and that it’s option expires in 10 days, with theta being -1.

You close your account on one of the top brokerages for options trading, and you’re happy. Your investment went through. Two days pass, and let’s assume that the underlying stock price doesn’t move and stays at $1950. You may think that this is not that bad, but the option you’ve bought actually has a lower value now.

Because two days passed, with theta being -1, your option is now worth $8 ($10 of your initial investment minus $2 because of theta -1, your option loses $1 of its value daily – concept of time decay, that we mentioned before). You start to get nervous. The only way your initial investment of $10 can return to that same number (or higher) is if the stock price jumps to $2010. Remember the intrinsic value we talked about before?

As a result of that price jump, the option would have at least $10 worth of intrinsic value ($2010 – $2000 strike price) that will cover the loss due to theta. This example shows how tricky options trading can really be and why you have to consider many different aspects when making a decision – with time decay being one of the most important ones. 

Theta Decay 💸

We can’t address enough how important time decay is as a concept to theta and for trading in general. That’s why we want to focus on it for a little longer and be nitpicky. Trust us; It’s essential to be knowledgeable on this subject, as it can help you understand different situations in trading that are far more complex.

There is a saying that between time and money, there is an equal sign. One thing is certain; time never stops, and it affects everything in our lives – including stocks. We can’t go around it, and we can’t stop it.

What’s the next best thing we can do? Try to use the time to our advantage. That’s why measurements such as theta exist – their purpose is to put time into the equation and calculate its impact on, in this case, stock options.

When it comes to option trading, traders can rely on theta decay as one of the (few) constants. As the expiration date approaches, long options lose their time value. It is a known fact that contract expiry accelerates the pace at which theta decay occurs. 

It’s hard to go against time – unless you like short option trading. In that case, we can say that the time is on your side (sort of) since the deterioration of value that occurs thanks to theta decay makes your trade profitable.

Timing also plays a vital role in trading. If the timing of your trade is correct, it can go a long way. However, if it isn’t, your trade can make a nasty turn in an unwanted direction. For example, the price of Moderna’s stocks (the company that makes Covid vaccines) skyrocketed after the vaccination started. It’s all about correct timing. 

How Option Writers View Theta 📝

In the world of trading, there are usually two sides of every single trade. The buyer, and the seller. As a trader, you can be on either side, depending on what you want to do with your investment. Same applies to options.

So, who are then option writers? Are they considered to be buyers or sellers? 

By opening a position, an option writer, also known as a granter or seller, sells an option and obtains a premium from the buyer. Option writer is essentially someone who generates a new options contract and offers it to a trader who wants to buy it. Based on this, we could say that option writer is considered to be a seller. But, let’s talk a bit more about these two different roles in a transaction, and how theta and time decay affect their positions. 

Since buyers are in most cases opening a long position, theta doesn’t work in their favor and is considered to be negative. As we said, time decay makes the value of an option reduce as it gets closer to its expiration date and therefore, buyers have to consider that. The more they stay in the long position, the higher is the chance that their option will lose value.

Conversely, theta is beneficial for option writers due to the fact that options written lose value as the expiration date approaches. Since they are mostly opening short positions, theta works in their favor as they are “betting” that the option will lose its value – which will happen thanks to theta (all other things constant).  💰

The potential reward for the writer can be the premium that they receive from the buyer. As appealing as this may be, writers face several risks – price movement being the first. That’s why it’s always a good idea to include stop-losses in your positions and monitor them closely.

Theta-Based Options Strategies 🎓

When trading options, it’s essential to have several proven strategies in mind that you can use. Nowadays, everyone can state that they are an expert, and you must steer away from unproven sources that can only hinder your investment.

Investment tips found on TikTok or Instagram can be potentially not-terrible, but they definitely shouldn’t be your main source of information. Instead, proven literature offers various strategies you can try yourself, and you should learn from your own experiments.

The strategies we’ll list below focus on the passage of time and take advantage of it. That’s why theta plays a crucial role in their understanding. But, at the same time, they do have their own set of risks that you should be aware of. 

Short OTM Vertical Spread 💳

There are also two types of short vertical spreads – call and put. For short call vertical spread, the trader needs to sell a call option that is OTM (or closer to ATM), and then buy a call option that is further away from ATM.

For short put vertical spreads, traders need to sell a put option that is OTM and then buy a put option later that is further away from the ATM.

If it’s a short vertical call spread, then it has two call options. In contrast, if it’s a short vertical put spread, two put options are present. Depending on the underlying stock, call verticals are usually considered to be bearish, while put verticals are bullish. 

Iron Condor 🦅

The following strategy is called the “Iron Condor.” This strategy is a mixture of short OTM put and call vertical spreads we already mentioned. As seen in the image below, we anticipate that the underlying security will stay in the “profit” range – between two short strikes, as that is where we have profit.

Typically, both vertical spreads are considered to be OTM and centered at the current price of the underlying asset. Theta is solely responsible for Iron Condor profits, as OTM contracts have no intrinsic value. Because of this, it’s not advisable to open Iron Condor setup with options that have far aways expirations, as the risk of unexpected breakout outweighs the low theta decay.

But, unlike in the previous strategy, the directional bias of the “Iron Condor” doesn’t depend on the underlying security. In fact, we could say that it’s neutral. Assuming that the underlying value remains between two short strikes until expiry, both vertical spreads will be worthless at the end of the trading day.

Calendar Spread 📅

When using vertical spreads and “Iron Condor,” keep in mind that the strikes are all inside the same expiry period. Those strategies aim to target the theta when it is at its maximum – by placing shorter strikes closer to the ATM than the longer ones. 

Calendar spreads work differently and target the theta’s tendency to accelerate as the option approaches the expiration date. The trader sells a short-term option in this strategy and buys a longer-term option, preferably of the same type.

Thanks to theta and its nature, the short-term option will lose its value much faster than the long-term option. This means that you can be profitable if you sell your long option for more than you originally paid for the short option. 

Theta Options Trading Mistakes to Avoid ⚠️

We know that using “Greeks” in options trading can initially be hard to do, but with enough practice, you’ll make it work. Besides the obvious mistakes that over two-thirds of traders make (emotional and impulsive investing decisions), others are unique only to theta. We’ll list some of them.

We said that when using theta, “everything else is equal,” or in other words, external factors are held constant. While this is true for calculating the measurement, it’s always a good idea to keep an eye on volatility and liquidity when trading.

Significant fluctuations in liquidity and implied volatility will always impact the price movement of the underlying security and the respective option. 

Setting a profit target is also very important when using theta. We know that it can often be hard to choose when to buy and when to sell, but we can assure you that it’s always a bad idea to be greedy and ask for more than you know you should. You know the saying – a bird in the hand is worth two in the bush.

Lastly, it’s essential that you know all fundamentals of theta and how it works. Even experienced traders sometimes have issues when it comes to incorporating theta in their setups. Learn, make several test trades, go back to learning, and repeat the process. If you want to become experienced in theta trading and trading in general – this is the recipe.

Conclusion 🎬

When you compare options and stock trading, you’ll see that the former is far more complex. If you’re new in options trading, it’s important to understand essential indicators that can help you in trading choices. Theta, one of the “Greeks,” is an important measurement that sits at the top of the list.

Understanding how theta works and how you can use it to your advantage is essential if you want to be a better options trader and if you want to make smarter investment choices. Time decay is an important concept in trading, and theta is a vital measurement that you can use to turn the tides of time in your favor – hopefully, this article helped you understand that.

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