Options Greeks: Theta Risk and Reward

Theta is the decay of an option’s value over time. Often times, traders refer to it as the “silent killer” of option buyers since it occurs slowly over time. Traders may look great on paper, but Theta can turn out to be a death from a thousand cuts. Theta values are always negative for long options and will always have a zero-time value at expiration, since time only moves in one direction and time runs out when an option expires.

For example, the table below shows AAPL options that expire in three months assuming a $157.44 current price. The in-the-money call option with a $139.00 strike price has a Theta value of -0.025, which means that the option price will decline about $0.03 per day. The at-the-money call option with a $157.50 strike price has a lower Theta of -0.054, which means that it will decay at an accelerated rate of $0.05 per day.

Theta values appear smooth and linear over the long-term, but the slopes become much steeper for at-the-money options as the expiration date grows near. The reason is that the extrinsic value of the in- and out-of-the-money options is very low near expiration since the likelihood of the price reaching the strike price is low. At-the-money options may be more likely to reach these prices, but if they don’t, the extrinsic value must be discounted over a short period.

How Theta Impacts Strategies

Theta is good for sellers and bad for buyers. A good way to conceptualize the idea is to imagine an hourglass where one side is the buyer and one side is the seller. The buyer must decide whether to exercise the option before their time runs out, but in the meantime, the value is flowing from the buyer’s side to the seller’s side of the hourglass. The movement may not be extremely rapid, but it’s a continuous loss of value for the buyer.

The table below shows the position Theta for common option strategies, but in general, these are easy to categorize since selling or net selling will always have a positive Theta and buying or net buying will always have a negative Theta.

It’s important to remember that Theta assumes that implied volatility and price movement remain constant. While Theta is removed from the price of an option each day, other factors influencing the price of the option – such as volatility – also have an impact on the value. In other words, you can’t look at Theta in isolation when analyzing an option strategy.

The Bottom Line

Theta represents the time decay of an option on a daily basis. In general, the highest Thetas are found at-the-money and closest to expiration. Options traders should understand how Theta impacts their option positions, especially in long positions approaching expiration.