Understanding Time Decay in Options Through Theta

Theta (θ) is an important Greek in the options trading. It measures how much an option’s price declines each day simply because time is passing. It is a process known as time decay.

This makes Theta essential for understanding how options lose value as expiration approaches.

What to Know About Theta in Options Trading

  • Theta quantifies the daily loss in an option’s extrinsic (time) value, assuming all other factors like price and volatility stay the same.

  • For example, if an option has a Theta of -0.05, it means the option’s price is expected to drop by $5 per contract per day ($0.05 x 100 shares).

  • The closer the option gets to the expiration, the faster this decay happens. It is because Theta accelerates sharply in the final days.

The Role of Theta in Extrinsic Value Decay

An option’s total price is made up of mainly two parts:

  • Intrinsic value: It is the amount by which an option is “in the money,” meaning how much the asset’s price is above the strike price for calls or below it for puts.

  • Extrinsic value: It is the additional amount traders pay for the time remaining until expiration and the potential for the asset’s price to move.

Theta directly measures how the extrinsic value drops each day. As time runs out, this extra value also disappears.

How Theta Affects Different Option Positions

Long Options (Buyers)

If you buy calls or puts, Theta will work against you in long options. Every day, the option loses some value just because the time is passing. Therefore, the primary asset needs to move favorably enough to offset this time decay.

Short Options (Sellers)

In short options, if you sell options, Theta works in your favor. Each day that passes, the options you sell will lose value. This increases your chances to buy them back cheaper or let them expire worthless and keep the premium as profit.

Understanding Theta’s Role in Risk Management

Theta serves as a risk measure which is tied to time.

High Theta means the option’s value will decrease quickly. Hence requiring more significant moves in the underlying asset to maintain the profitability. This is why short-term, at-the-money options often have the highest Theta.

Common Theta Values in Equity Options

This shows how Theta typically changes with time to expiration and whether the option is in, at or out of the money.