Characteristics of Theta
Dec 1, 2017
By: Sage Anderson
The "Greeks" are critical metrics in the realm of options trading, and today we are providing more context on one in particular - theta.
As a reminder, the collective "Greeks" are parameters that measure the sensitivity of an option's value to changes in the following: underlying price, time, volatility, and interest rates.
Theta is the greek that measures the rate of change in an option's theoretical value relative to the passage of time. This concept is often referred to as "time decay," because all else being equal options lose value as they approach their expiration date.
For example, if option XYZ is worth $1 with five days until expiration, the theta of that option would be equal to $0.20. For each day that passes, that option will theoretically lose $0.20 in value.
A recent episode of Options Jive takes a closer look at theta and some important characteristics traders should be aware of.
The four high-level characteristics of theta discussed on the show include the following:
Theta is larger for shorter duration options
Theta is larger when implied volatility is high
Theta decay is largest for at-the-money (ATM) options
Theta's rate of decay increases as expiration approaches
Traders can use an understanding of these characteristics to ensure they are deploying portfolio exposures that match their risk profile and outlook.
Looking at the first bullet point above, we see that shorter duration options possess larger theta. This makes sense because a longer-dated option will have a greater number of days remaining until expiration. At that point in the option's life, each passing day removes only a small percent of the total option's value.
However, heading into the final weeks and days before expiration, that same option will start to lose a large portion of total value as it ticks toward expiration.
Per the second bullet point, theta is also higher when implied volatility is inflated. This fact is a cornerstone of the short premium approach, which seeks to exploit mean reversion when uncertainty increases (i.e. volatility goes up).
Given the relationship between risk and reward, it also shouldn't come as much of a surprise that theta is larger for at-the-money (ATM) options.
The closer an option is to the current price of the underlying, the greater the likelihood that it finishes in-the-money (ITM). That means that the risk of selling premium in such options is higher than that of out-of-the-money (OTM) options.
For this reason, ATM options will always have higher premiums than OTM options, and consequently higher theta as well.
Here at tastytrade, we think the space between ATM and OTM options (i.e. one standard deviation) is a good place to look for short premium opportunities. This reduces potential risks to the portfolio by avoiding ATM options, but also allows for the possibility of earning an attractive return by not staying too far out-of-the-money.
A trader's own unique risk profile and approach will, of course, dictate what type of options are traded (ATM, OTM, etc...).
While strike is an important component of trade selection, time until expiration is another consideration, which is emphasized by the fourth bullet point listed above.
As expiration approaches, the rate of decay in an option's value increases. This phenomenon can also be tied back to the risk versus reward equation. With a month left until expiration, an underlying could make a big move against our short premium position.
However, a month leaves time for the underlying price to retrace its value, and for the position to move back in our favor. With only a week or a few days until expiration, the risk of a big move in the underlying is greater, because there's less time for the underlying to retrace.
It's for this reason that we often target 30-40 days-to-expiration (DTE) when selling premium, and also consider utilizing a trade management technique (e.g. managing trades at 50% of max profit).
While trading shorter-term options may allow traders to capture a higher rate of decay, the risks of such a strategy are also inflated - much like trading options that are closer to the strike.
In order to gain the best possible understanding of theta, we hope you'll take the time to review the complete episode of Options Jive when your schedule allows.
If you have any questions about theta as it relates to a particular position or your overall portfolio, we hope you'll leave a message in the space below or reach out directly at email@example.com.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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