Theta is the greek that measures the impact of time. Options have time value, and Theta measures how fast it decays.
Theta is defined as the amount an option will change in time value in a day. Theta is always negative. Option prices always decay because of time. Options have a time value- the longer it is until expiration, the more expensive an option is. As time passes, options lose value. Theta is the measure of how much value is lost just based on the passage of time.
For example, today an option has a premium of $2.00 and a -0.05 theta value. If nothing else changes, the premium will be $1.95 tomorrow.
If you sell options, theta is your friend. I like to think of theta as my daily paycheck. Time decay and theta are the primary reason I use most of the strategies I do. Prices and volatility are unpredictable, but time always passes no matter what.
If you buy options, theta is constantly eating away at the value of your holdings. Your strategy has to overcome the impact of theta. Because of theta, I avoid buying options unless I hedge them with a sale or use them as a hedge for a more lucrative sale. In our discussion of strategies, theta is a key consideration.
In every strategy involving options, theta is a key metric. You must maximize its positive impacts and minimize its negative impacts to be successful.
A really nice feature of theta is that it can be easily added together between different underlying securities to give you a measure of the total theta impact. There is nothing to scale up or down based on price or any other factor- time is the same no matter how volatile or expensive the underlying security is. We’ll dig in deeper later in how to utilize portfolio theta to consistently generate income.
There are some limitations to theta. Theta can easily be cancelled out by price and volatility changes. Because of this, you can’t count on predictable decay every day based on theta.
Anyone who has studied options knows that option time value decreases faster as you get closer to expiration. Options are always decreasing in value, but a lot of value disappears close to expiration. The logical conclusion that many people have is since decay is most extreme near expiration, this is the best type of options to have in your portfolio so you can maximize the impact of theta on your short options. I thought this when I started selling options. However, there are two problems with this. The only options that have time value left near expiration are ones that are close to the money. It doesn’t take much of a price change to move a slightly out of the money option into the money, and with time short there is no time for a recovery the other way. For options further out of the money, their time value erodes earlier, and a seller can close a position before expiration without worrying about a small move eliminating profit. We’ll go through these scenarios in more detail later, but this was a lesson that took me a while to learn through hard knocks.
One of the most popular subs on Reddit is called \thetagang. There are many traders out in the option world that focus extensively on Theta.
Theta is one of the greeks I pay close attention to, both when I’m deciding what positions to open, and when to exit out of a position. It’s one of the key metrics I look at to manage my option portfolio. While I can’t say that it is the most important greek, I can say it is my favorite, because I think of it as my daily paycheck. My goal is to use the other greeks to manage my positions so that I can collect all of my theta paycheck.
