If you don’t already understand delta and gamma, you should check out how to use delta and gamma in my trading. Now, when you’re in the world of options trading, there are a few primary factors affecting an option’s price. Delta and gamma are important to take into account when you’re position trading, as well as theta. When I’m trading, I take these into account and can multiply my money – check out how I do that here.
Theta is a very important Greek, or sensitivity, to take into account. You see, options are wasting assets and theta measures how an option is affected as the expiration date nears. That said, let’s take a look at how to take theta into account when you’re getting your toes wet in the world of options trading.
Options trading: Theta Explained
The pros know that they need to take into account the effects of data on their options positions. In the world of options trading, theta measures how much an option’s value may be affected per day, or week, with all other factors being equal.
Now, when you’re long options, the prices of those options will decrease as the expiration date nears. On the other hand, when you’re short options, which I don’t suggest any beginner to do, theta decay will benefit position, all else being equal.
In theory, theta, or time decay, is not linear. In other words, the rate of decay would tend to increase as the expiration date nears. We’ll tend to see theta increase gradually. However, once the expiration date gets closer and closer … the theta value starts to pick up.
On the expiration date, the option has little to no time value left and trades at the intrinsic value … if there is any intrinsic value.
There’s one thing to know when options trading, the pricing models take into account weekends. That in mind, options tend to decay seven days over five trading days. Additionally, there is no industry standard for theta, so different pricing models will show different theta values.
Options trading – How to interpret theta values
If the theta value is high, the current options trading market may look too high. On the other hand, if a pricing model shows theta is low, current markets might look cheap.
For example, assume a stock is trading at $100 and the at-the-money call options were trading at $2. Additionally, assume those options have a theta of 0.05. That means the holder of those options could expect those options to lose 5 cents per day, all else being equal.
Now, if one day passed and there’s no change in the option price…or the option price increase…then another variable changed. In general, if this occurs, the level of implied volatility increased.
If those options decreased by more than a nickel, then the implied volatility may have decreased. Recall, if the expiration date nears, the theta value should become more negative.
Here’s a look at how theta looks on a chart.
It’s a little messy, but you’ll notice the options with closer expiration dates have higher theta values.
Options trading: Theta and implied volatility
Theta and implied volatility go hand in hand. You see, implied volatility affects the extrinsic value, which affects theta values. In general, the higher the implied volatility, the higher the theta.
Now, at-the-money options tend to have the most exposure to time decay. Options that are deep in the money or far out of the money tend to have little time decay, since they have less premium.
Here’s a look at an options chain.
Take note how the theta values for deep in the money and far out of the money options are very close to 0.
Understanding theta decay is extremely important when you’re trading options. You should have a basic understanding by now, if you’re ready to get a deeper understanding – check out how you can do that here.
Options trading might seem tedious at first. However, once you understand the basics and factors affecting options…it becomes easier. Now, if you want an inside look of how I make money in the options trading world, check my strategy out here.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.