Using the Greek 'Theta' in Option Trading

Don't Let an Option's Time-Decay Eat Into Your Profits

Dec 14, 2008

Not only do option traders have to predict a stock's direction, they have to beat the clock too. Wise traders learn how to minimize this time-decay known as 'theta'.

Like it or not, the sheer passage of time is taking money out of an option trader’s pocket. Sometimes it takes very little. Other times, it takes a lot. Either way though, all options lose value every day simply because as time passes, an option’s speculative value is diminished. The pace at which an option loses value over time - referred to as time decay - is called theta.

Since an option trader’s primary goal is maximizing profits, it may be time well spent to minimize the ill-effects of time decay. In short, low theta values are usually more desirable for option owners. (Option sellers or credit spread traders actually prefer a high theta, though that’s a different strategy.)

Gauging Theta

Theta is always cited a positive number, whether for a put or call. However, it's always a measure of how much value an option is losing over time.

Like all option Greeks, theta is also usually listed as a decimalized figure. A theta value of 0.07 simply means that for each share of a 100 share contract, that contract loses 7 cents per day. Or, the entire contract loses $7.00 in value every day. This daily loss includes weekends.

As was stated above, most option traders – the ones who only buy options and attempt to resell them for a profit later- prefer a low theta. Why? Lower thetas reduce the toll of time on their profitability.

Those lower thetas come at a price though… literally. In general, options with low thetas also cost more than options with high thetas. Depending on other factors, it may be entirely possible that a low-theta option is actually less advantageous than a high-theta option is, if the low-theta option’s price is disproportionally higher. This is why any trader must carefully weigh the upside and downside of several different option choices.

Still, low-theta choices are frequently preferred due to their palatable risk-versus-reward scenarios.

Other Influences on Theta Values

Options that aren’t all that deep in the money tend to have proportionally higher thetas than options that are deeper in the money. In terms absolute dollars and cents, theta values may actually be higher for deeper in the money options. However, in percentage terms, the higher the option price, the lower the theta value.

The time left until expiration also affects theta values. Generally speaking, the more time an option has until expiration, the lower the theta is.

On that note, however, a trader must also understand that as time passes, an option’s theta value can increase. Since these valuations aren’t static, option traders should at least mentally account for the pace of time decay to accelerate as time moves along.

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