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What is Theta?

 

Theta is defined as the change in the price of an option for a 1-day decrease in the time left for expiration. At-the-money options have the greatest time value and the greatest rate of time decay (theta). The further an option goes "in-the-money" or "out-of-the-money", the smaller is theta. As volatility falls, the time value declines and hence theta also declines.

  • Theta is the rate at which an option loses its value as each day passes.
  • The inherent assumption is that the options are a "wasting asset."
  • Long options have negative theta
  • Short options have positive theta

 

As time passes, the theta of at-the-money options increases, the theta of deep in-the-money and out-of-the-money options decreases.

Theta has the exact opposite characteristics of gamma. Thus the size of a gamma position correlates to the size of the theta position. A large positive gamma position goes in hand with a large negative theta position, while a large negative gamma position goes hand in hand with a large positive theta position. What this means is that every option position is a tradeoff between market movement and time decay.

Theta is not used much by traders, but it is an important conceptual dimension. Theta measures the rate of decline of time-premium resulting from the passage of time. In other words, an option premium that is not intrinsic value will decline at an increasing rate as expiration nears.

 
 
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