Options Greeks Explained: Theta
Given that options are a contract that expires at one point or another, the option greek “theta” provides a measure of time decay or the change in an options value with each passing day. Remember that at expiration, options only contain “real” value as the “time” value evaporates, so theta is an important factor.
- Long calls/puts have a negative theta
- Short calls/puts have a positive theta
With a long option position, theta is negative because as each day passes, the probability of that option ending up ITM decreases slightly. Think about it this way – Would you pay the same amount for an option that had 4 weeks to expiration as one that had 1 week to expiration? The answer is NO because you would have a much better idea of where the underling may end up with only 1 week rather than 4 weeks. This is why theta is negative for long options.
With short options, the exact opposite is true because when you are short an option, you are looking to buy it back at a cheaper price in order to profit. And as each day passes, the options value drops due to theta, thus short options profit with passage of time. Therefore, they are positive theta!!!
Example: You are long one call option with a theta of -$5 (.05*100). All else being equal, as each day passes, the call option will drop in value by $5.
As you get closer to expiration, theta gets “magnified” because the probability of an option making money decreases at a faster rate. There just isn’t enough time left for the option to make a big move. As a rule of thumb, theta gets bigger once you hit 1 week to expiration.
