Have you ever heard the phrase “time is money”? The same idea applies to options trading. Theta, also known as time value, refers to how much an option will decrease in extrinsic value per day. The amount of time left until expiration has a direct impact on the price and risk of an options trade. Theta can be used to analyze trades by calculating how much potential profit or loss could occur based on these factors.
What is Theta in options trading?
Theta is a metric that represents the amount by which the extrinsic value (or time value) goes down per day.
For example, an option with a Theta of 10 will decrease in value by $10 on the following day.
Of course, there are other factors that influence the value of an option contract as well, so it’s also important to familiarize yourself with those concepts.
Why is it important to understand Theta?
Whether you’re considering buying or selling an option, you should understand that Theta increases exponentially as the expiration date draws closer.
In other words, the closer the expiration date, the more rapidly the extrinsic value of an option will go to zero.
To illustrate this, let’s compare some different types of options trades based on time-until-expiration.
This contract will be more expensive because it contains more time value as a component of its total extrinsic value. Each passing day, the contract will lose some value, but not a huge amount.
You’ll likely see larger swings in option value due to other factors such as a change in implied volatility, or a change in the price of the underlying stock.
This contract will be less expensive because it contains less time value. Also, due to the exponential nature of time-value decay, weekly contracts will rapidly lose value each passing day as expiration draws closer.
What about longer-term options such as LEAPS?
LEAPS stands for Long Term Equity Anticipation Securities. Theta for these contracts is even less than monthly options because each passing day only represents a tiny percentage of the total time left in the contract.
As a result, you’ll typically see these types of contracts follow the underlying stock price more closely. As a result, traders will often purchase LEAPS contracts as a replacement for actual stock, allowing them to benefit from changes in the underlying stock without needing to shell out cash for 100 shares upfront.
The “Long” and “Short” of Options Theta
You might be wondering what to do with this information. That depends on which end of the option contract you’re on.
Long options (buying options)
If you’re purchasing options, you’re probably hoping to sell them for a higher price at some point before expiration. However, Theta works against you here, as your contract loses time-value each day.
In order for your trade to be profitable, you’ll need upward pressure on the value of your option that is greater than the amount of time value that is lost due to Theta decay.
Short options (selling options)
Conversely, if you’re an option seller, you’re hoping to either buy-to-close your option for less than you originally sold it for, or let the contract expire worthless to maximize your profit. In this case, Theta works in your favor.
This means that as expiration draws closer, and Theta increases, it becomes exponentially more likely that you’ll profit from the trade. Of course, this assumes that the contract is not in the money.
Theta is a metric that represents the amount by which the extrinsic value (or time value) goes down per day. You should understand that Theta increases exponentially as the expiration date draws closer. This means that high Theta can be a great tool for option sellers, but not so much for buyers. If you are an options trader and want to learn more about how using this metric might benefit your trades, contact us! We’re happy to answer any questions or set up some training sessions on understanding Theta in trading options with our team of experts. Do you use Theta to analyze your options trades? let me know in the comments!