Benefit from Theta Decay in trading Options

Theta Defines an Option’s Time Decay

Theta Decay is often referred to as time decay.  It describes the rate at which the value of an option will erode as day passes. Assuming that all other inputs are unchanged.

The theta number is calculated using an option pricing model. Theta is a component of a group of calculations that is called Option Greeks. These numbers are partial derivatives of the option price.

Why is Theta Important?

The value of an option is made up of two components e.g. intrinsic and extrinsic value. Intrinsic value may or may not be the same as the current market value. Additionally, intrinsic value is primarily used in options pricing to indicate the amount an option is in the money. It is the value of the option if it were exercised now. Extrinsic value is made of time value and Implied Volatility. When people expect that the markets or the underlying will change much the option prices are high. As a seller of options in order to receive options premium. For two reasons when volatility drops we will buy the option for a much cheaper price back. And secondly because of theta decay.

We typically sell options around 45 days to expiration. If you look at the picture below you see the premium erode very vast. As the option approaches its expiration date, the probability of an option moving in or out of the money with respect to the underlying decreases.

theta decay

 

Every option contract, call or put, will have zero time value at expiration and will then only be worth its’ intrinsic value if exercised. So, during an option’s life, it’s time value is eroding each and every day. Theta value estimates how much money will erode every day.

 

Positive vs Negative Theta

When looking at an option chain the contracts are always assumed to be long. as if you were to buy the call or put.  The option can lose value as time passes. Therefore the time value is negative. This is why Theta is always shown as a negative number for both calls and puts when pricing options. It means, it makes no difference whether you have the option to buy or sell the stock; that option becomes worth less each day that passes. The picture below shows an option chain.

If you sell options your position Theta is positive; you would benefit from the passage of time as expiration approaches.

This is fact is important for sellers of option premium. They sell options and receive the premium. They can keep the premium if the option expires worthless.

Selling a single option will create a positive Theta position. But you can also create a positive Theta position with multiple options i.e. option spreads.

Option traders refer to this as a strategy to “capture Theta”. Typically all option credit spreads (where the net premium is received by the trader instead if paid out) will be Theta positive. For example a short condors spread is a common strategy used with retail traders as a way to generate income from a positive Theta position.

 

Selling an out of the money option

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An option position with a positive theta value of 0.10 means you are short the position, and that the value will increase $0.10 for every one day that passes (all else equal). This generally means you sold the option, and the option loses $0.10 of value per day in theta decay, all other factors unchanged. This can result in profit if you buy it back at a lower price than what you paid.

It is important to understand that every option has an owner and a seller. If you sell a put, you will show a positive theta value of a certain amount, while the buyer of that same put will show the same theta value, but negative. The option will lose extrinsic value as its days until expiration go to zero. The seller of the option will profit from this passage of time, while the owner of the put will lose value (all other factors kept constant).

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