"Understanding Option ""Theta"""

Understanding option theta is a critical element of option trading because it directly impacts one of the two elements of an option’s value: time value and intrinsic value. Theta is the rate at which an option’s value changes for each passing day, with all other factors held constant. If you want to trade options, it is important to know how the time value of the option will be affected by the passage of time. This is different than intrinsic value (the value if the option were exercised immediately), which has a direct relationship to the price of the underlying. Theta, however, varies based on a number of factors ranging from the time remaining until expiration to the proximity of the price of the underlying and the option’s strike price.

Time Decay

The basic definition of an option contract is an instrument that gives the holder the right, but not the obligation to purchase a set quantity of an underlying security or commodity at a set price for a set period of time. Theta describes how much value the option contract loses as the expiration date approaches. Essentially, a large part of what you are buying with an option contract is the time you may need to make a decision. As the amount of that time decreases, so does the value of the option. This is known as time decay. Theta, then, can be understood as measuring the sensitivity of an option’s price to the passage of time. Theta is always negative for a long option, regardless of whether one holds a call or a put, and positive for a short option – as the option moves toward expiration, the writer of the option (the short seller) realizes an increase in value.

Accelerating Sensitivity

As an option moves towards expiration, its sensitivity to the passage of time increases, meaning that theta rises. This is driven by the fact that as the option gets closer and closer to expiration, each day represents a higher percentage of the remaining time left in the option. For example, with ten trading days left until expiration, the passage of one day means that the holder will lose ten percent of the time remaining. By contrast, when there are only five days left, the percentage that will be lost is twenty percent; by comparison, the later costs the holder a great deal more.

Distance from the Strike

Another significant factor that affects theta is how far the option’s strike price is from the prevailing market price of the underlying security. All other factors being held equal, theta is higher for an option whose strike price is closer to the prevailing market price of the underlying than for an option than is deeply in-the-money or out-of-the-money. An option’s price consists of the time value and the intrinsic value. A deeply in-the-money option trades near intrinsic value because the probability of a loss is near the probability of further gain. For a deeply out-of-the-money option, theta moves more slowly because realizing intrinsic value requires a significant move in the underlying security. Therefore, options that are at-the-money will have the highest theta. These factors and others can have a significant effect on the price of a given option contract.