Theta, or time decay, is the term to describe how option prices decrease over time.
Every day, an option’s price gets a little cheaper. Why is that? As time passes, it becomes less likely for the price of the stock to have a large change for a given volatility. So, options that could make money from a large price change become less likely to make that money, and therefore become less valuable.
Knowing this, as well as the fact that the passage of time is inevitable, makes theta a key metric to use to become a profitable trader.
The way to get theta on your side is to sell options short, calls or puts. Short options have positive theta, and long options have negative theta. When you buy options, theta is working against you. That’s why we focus so much of our trading on short option strategies, like short puts, short strangles, short iron condors. All those strategies have theta working for them. They can make money simply by time passing.
Theta only affects the extrinsic value of options. In the money option prices are composed of intrinsic value and extrinsic value. Out of the money option prices are purely extrinsic value. It’s the extrinsic value that decays. Intrinsic value does not.
While you can short in the money options, we sell out of the money options to
generate positive theta mainly because they are more liquid than in the money options.
Theta is not constant over time, however. Theta increases exponentially the closer the option is to its expiration. With more days to expiration, theta is lower. With fewer days to expiration, theta is higher. That means an option’s extrinsic value decays faster and faster as time passes. This helps us choose which option to short as part of a strategy. We balance the rate of theta with the level of the option’s extrinsic value by shorting options that have between 35 and 55 days to expiration.