This is the third installment of a four-part series about options Greeks on Market Insights concluding Labor Day week.
Theta: T is for “time decay.”
Theta measures how much time value an option loses each day. Therefore it’s always as negative number. Theta is expressed outright in cents.
Off the bat, remember we’re talking about time value, or extrinsic value. Options with expiration dates further into the future have more time value.
As some readers may already know, options lose this time value at a faster pace as expiration approaches. (The logic of this is simple: Because all kinds of craziness, or volatility, can happen over longer periods, options price in the potential for that uncertainty. But shorter time frames have fewer potential unknowns. Click here for our case study of a strategy that profited from time decay.)
Let’s take a look at the options chain for Apple (AAPL) shown below. Notice how contracts closer in time have bigger absolute values for their thetas? September calls lose $0.08 or $0.09 per day, Octobers and Novembers lose $0.06, and Decembers a little less, etc.
You’ll also notice that theta tends to be the mirror image of gamma. Shorter-dated options have more gamma (price leverage) but lose time much faster. This is another way of understanding risk and reward. Everything has a price. In this case, the price of leverage is faster time decay.
It’s great if you’re right, but costly if you’re wrong. There is no free lunch — at least not in financial markets!
Here are some ideas on how to apply theta in your own trading:
- Beware of buying options with higher thetas because they give you less time to be right about the direction a stock will move.
- When selling options, it may help to select contracts with higher theta. They’ll lose value more quickly, so it can potentially make sense to short those. (Always remember the risks of selling options.) And remember that a quick move will “hurt more” because you’ll be short gamma as well.
- Theta is a key principle in horizontal spreads (also known as calendar spreads) and diagonal spreads. These strategies essentially own longer-dated contracts and sell shorted-dated contracts as a way to shift different thetas in your favor.
In conclusion, theta is an important concept for clients new to options. Using it correctly may help you trade more effectively. Next week, we’ll explore “vega.”