How Theta Decay Works

2022-06-13 | Bruce Marshall

Trading options is a complex and risky trading method, but it may be surprising to some traders when dealing with options that they need to be aware of the Greek alphabet. The Greek symbol we want to focus on is Theta.

Theta is one of the most important concepts for options traders to understand. Theta explains the effect of time on the premium of options that have been bought or sold. This article will clearly define Theta and how it applies to your trading strategies.

What is Theta?

In options, Theta is more than just a symbol in the Greek alphabet; Theta is a measure of the time decay of an option. For options that a trader purchases, this is the dollar amount that an option will lose each day due to the passage of time. 

Examples of options that traders buy: 

For options a trader sells, this is the dollar amount that an option will gain each day due to the passage of time. 

Examples of options that traders sell: 

Understanding Theta is critical for traders who want to delve into options. As you can see, Theta can either work against you or for you; as the trader, you have to conduct your research on which way you want to trade.

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Trading with Theta

When you are trading options, you will find many different ways to trade them. Regardless of how you trade options, Theta is a key component of the value of options that all traders should be familiar with. 

Whether your option is in-the-money (ITM), at-the-money (ATM), or out-the-money (OTM), Theta decreases as an option approaches expiration (like a bell curve as shown in the red line below).

They Decay

Theta and Days To Expiration (DTE)

The further out in time you go, the more negligible theta decay will be for an option until the option nears expiration; then, theta decay speeds up. If you want to buy an option, it is often advantageous to purchase longer-term options. If you want a strategy that profits from theta decay, you will want to sell the shorter-term options. Due to theta decay, the loss in value happens quickly and can be to your advantage.

Each moment that passes melts away some of the option’s value. Not only does the premium melt away, but it does so at an accelerated rate as expiration approaches. Because the price of an option tends to erode over time, Theta takes the form of a negative number. However, it depends on what side of the trade you are on – buying or selling.

Mathematically, think of theta decay as a negative number when buying options and a positive number when selling them. Theta is enemy number one for the buyer of the option and the best friend of the options seller.

Calculating Theta Decay

If we focus on at-the-money (ATM) options, there is an easy way to calculate how quickly the time premium decays. (ATM) options work best in this example because their prices only consist of time value. At-the-money (ATM) options move at the square root of time. 

If a one-month ATM option is trading for $1, then a two-month ATM option would be trading for 1 x the square root of 2, or $1.41. A three-month ATM option would be trading for 1 x the square root of 3, or $1.73.

When we plot these points graphically, you can see the accelerated curve of decay.

Graph of Theta Decay
Theta Decay showing the time that remains when an option goes through Theta Decay.

Depending on which strategy you choose, we want to buy and sell where there is the most rapid decay (seen toward the right side of the image).

Since the time decay of ATM options accelerates as expiration nears, it makes sense that Theta is a more significant number for near-term options than for long-term options.

Negative Theta

Let’s look at buying a call on GOOGL, for example. If you have this position (as shown in the image below), Theta is at –254.19. This means you are losing approximately $254.19 per day. After two days, you would be down over $500 in value assuming there was no price movement for the sake of this example.

Positive Theta

On the flip side, when you are selling a call on the same GOOGL position, you would be making $254 per day. After two days, you would make over $500, again assuming no price movement.

Theta Effect on Your Whole Portfolio

It’s not only helpful to look at Theta on individual options. It would help if you also considered net Theta across your entire portfolio. If you are net-long options in your account, your portfolio would have a negative Theta. In other words, your portfolio would lose value from Theta decay each day that passes.

If you are net short options in your account, your portfolio would have positive Theta, which means your account value will benefit with each day that passes and gain value each day. There’s a saying, “Do you receive a Theta check every day, or do you have to write a Theta check every day?”

How does volatility affect Theta?

Theta will become a larger negative number for both near and longer-term options if volatility increases. As volatility decreases, Theta usually becomes a smaller negative number. To put it in plain terms, a higher-volatility option tends to lose more value due to time decay than a lower-volatility option. 

If you’re drawn to buying higher-volatility options for the action they bring, keep in mind that you’re also fighting time decay, which is more challenging with these contracts. On the other hand, you may be more drawn to selling these higher-volatility options because of their more rapid decay rate than lower-volatility.

What to look out for When Trading Theta

It is vital to remember that Theta decay is a metric that assumes the price and volatility of the underlying stock are constant. In reality, the markets are constantly moving. While the value of Theta will affect the option’s worth, this also depends on the changes in price and volatility of the underlying stock. Theta will constantly be eating away at the value of an option as time goes by, which can be positive for sellers but negatively impacts buyers.

In conclusion, time decay is the option seller’s friend and the option buyer’s enemy. Options traders should understand how Theta decay affects the premium of the options that have been bought or sold. So, when you are ready to start trading options, understand the risk and do your due diligence in the market before making that trade. 

Dealing with options and theta decay can be a daunting task when trading options; here at Simpler Trading, we understand how daunting it can be for traders. If you still have questions, consider joining Options Gold. By becoming a member, you’ll be joining a community of traders led by an expert trader that can guide and mentor you through your trades. Why trade alone when you can trade with us? Sign up today.

FAQs on Theta Decay

Q: What is Theta decay?

A: Theta is a measure of the time decay of an option, the dollar amount that an option will lose each day due to the passage of time.

Q: How does Theta affect options?  

A: All options experience theta decay. As the option contract gets closer to expiration, theta decay occurs at an increasing rate (it speeds up). Allow yourself enough time for your trade to work out – buy further out options, so theta decay doesn’t hurt your position as much as if you bought shorter-term options.

Q: How does Theta decay work?

A: Each moment that passes melts away some of the option’s value. Not only does the premium melt away, but it does so at an accelerated rate as expiration approaches. 

Q: How to calculate Theta decay?

A: ATM options move at the square root of time. If a one-month ATM option is trading for $1, then a two-month ATM option would be trading for 1 x the square root of 2, or $1.41. A three-month ATM option would be trading for 1 x the square root of 3, or $1.73.

Q: Can a beginner trade options?

Options can be good for beginners because you have no obligation to do anything if you’re not happy with the direction your contract is moving. Additionally, options allow for a more conservative approach and smaller capital requirements.

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