For new and experienced options traders, it is always good to review foundational principles.
A term that you may have heard when it comes to trading options is theta. So what is Theta when trading options?
Theta is one of the group of measures known as the Greeks, and it is one of the factors used to determine the value of an option.
Other factors in this process include the difference between the stock price and the strike price, the duration of the option contract, the market volatility, the implied volatility of the underlying security, the quality of the underlying, and other considerations.
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Options Theta Definition
Theta is a measure used to describe the rate that an option’s value will decay with all other factors staying the same (primarily price of the stock and implied volatility).
Theta represents the daily time decay of the extrinsic premium - options traders refer to this as theta decay.
Theta is usually expressed as a negative number as it is used to describe how an option’s value will depreciate as it matures.
As an option matures and moves closer to its expiration date, the theta value increases as well.
This means that the option’s value will decay at a faster rate as it gets closer to the expiration date.
Theta is a good basic options trading concept to understand; however too much analysis can affect your options trading decision-making process.
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Option Theta Example
If the current value of an option is 7.50 and the option has a theta of -.05. After one day, the option’s value will be 7.45, 2 days 7.40. Etc.
Is Theta Good for Option Traders?
Theta is something that benefits options sellers as it is directly tied to an option’s value.
When an option expires, option sellers are usually able to keep all of the premium (if an option expires out of the money).
For buyers, the opposite scenario is true. If you buy an option, theta is working against you, as the value of the option decreases over time.
As an options buyer, there are many other factors that are working against you, and it can be difficult to make a consistent profit from buying options.
Even so, it's very important to buy options to hedge your portfolio against large swings in market volatility and to reduce drawdowns.
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David Jaffee has taught over 1,500 students how to sell option premium.
If you’re new to options trading, theta and theta decay is one of the fundamental concepts that you should understand.
However, there are other important components to learn such as implied volatility, market volatility, how to choose stocks and indices for your watch list and how to determine whether to make a trade.
These are all important factors that you should consider when you’re selling options.
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Frequently Asked Questions (FAQs)
What is theta when trading options?
Theta refers to the daily rate of decline in the value of an option's extrinsic premium. If all other variables are constant, an option will lose value as time draws closer to its maturity.
Is high theta good when trading options?
High theta means that the option will decay rapidly on a daily basis. This is good for option sellers, but bad for option buyers.
Should I close out options trades early?
In general, if I've realized a large profit in a short amount of time, then I'll close out the position and redeploy the capital.
It doesn't make sense to wait ~80% of the remaining time, only to collect ~30% of the remaining premium.
Should I use an options theta calculator?
In my opinion, I don't believe an options theta calculator will help you.