Key Concepts 4. Portfolio Management

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Theta

Theta is the daily decay of an option’s extrinsic value. This metric is the cloudiest of all, as it assumes implied volatility & price movement are held constant. For this reason, it’s better to think of theta decay from the bigger scheme of things.

If we have positive theta, we’re on the right side of the coin. To obtain positive theta, we can sell options. All options with time left until expiration will have extrinsic value. As an option seller, this decay is a good thing. Let’s say we sell a put for $1.00. To close the position, I need to buy back that same option. In order to realize profit, I need to buy the option back at a lower price. This is why theta is shown as a positive value for option sellers. The daily decay of an option price will help us realize that profit sooner.

If we have negative theta, we’re on the wrong side of the coin. To obtain negative theta, we would have to buy options. Having negative theta is not a fun feeling, as we are trading against the clock. The extrinsic value of our options will dissipate over time, which means we have to be directionally right quickly in order to see a profit, or we need implied volatility to expand more than theta will decay the option. This is why we always hedge our long options with a short option. We prefer long vertical spreads, calendar spreads, and diagonal spreads compared to long naked options, because we can eliminate a lot of the decay, if not all of it.

The most important aspect of theta to remember is that it assumes implied volatility & price movement are held constant. Markets move every second, so it is unrealistic to expect them to be frozen. We can’t look at our options and expect the value to decrease by theta every single day. While theta will come out of the option, price movement & implied volatility will change the value as well. As long as we’re on the right side of the coin (positive theta), we can rest assured that our option’s extrinsic value will get lower and lower as we reach expiration, which is one of the keys to success for an option seller.

Theta Videos