When you trade options, the price you pay (or are paid) for an options contract has two components: intrinsic value and time value. Intrinsic value can be thought of as the value of the option if it were exercised today.
For example, if you have a call option that allows you to buy a stock for £20 and it is trading for £22, the intrinsic value of the option is £2. Conversely, if your option allows you to buy a stock for £20 per share and it is trading at £19, your option has no intrinsic value.
That doesn’t mean the option is worthless, however. There’s also a component called time value that is based on what the stock could do between the present time and when the option expires. And that’s where theta comes in.
What is theta in options trading?
Theta is the decay in an option’s time value that occurs as it gets closer to expiration. Think of it this way: If you own an option to buy a stock for £20 that trades for £15, the option is more valuable the longer it has to get to the £20 strike price. If the option expires in a year, it will have more time value than if it expires in a month, all other factors being equal.
For this reason, theta is also referred to as the time decay of an option. It is usually a negative number for options you own and a positive number for options you sell.
The “Greeks” in options trading
Theta is one of five metrics used in options trading that are collectively known as “the Greeks.” Just to give a quick overview, here are all of the options Greeks and what they are used for:
- Delta: The sensitivity of an option’s price to changes in the price of the underlying stock, ETF, or other asset. For example, delta can tell you how much an option’s price might change if the underlying security increased by £1 per share.
- Gamma: This is the change in delta caused by changes in options prices. Without getting too mathematical, options that are far out of the money have lower deltas (price sensitivity) than those that are near the money or in the money. Gamma is used to describe this relationship.
- Vega: The change in an option’s price due to the volatility of the underlying asset. You may have noticed that options on volatile stocks tend to be more expensive than those that have low volatility. Vega is used to quantify this.
- Theta: As discussed throughout this article, theta is an option’s sensitivity to the time until expiration.
- Rho: Sensitivity of an option’s price to changes in interest rates. Options aren’t terribly sensitive to changes in interest rates, but they do have some impact.
Why is theta important to know?
An option’s time value will head to zero as it gets closer to its expiration date. This is true whether the option is in or out of the money.
Time decay is a big risk in options trading. For example, if you buy a call option with a £35 strike price on a stock that trades for £38 per share and pay £5 for the option, it has £3 of intrinsic value and £2 of time value.
Example of theta
Let’s say that you buy a call option with a strike price of £30 and that you pay £3 per share for the option. The stock is trading for £31, so there is £2 of time value in the option’s price. If the option has two months to expiration and a theta of -£0.05, it should theoretically lose £0.05 in value per day.
Now, this assumes that the underlying stock price stays the same. If the stock price rises, the value of the option will rise as well, although it is still losing time value as it gets closer to expiration.
It’s also worth noting that time decay isn’t a linear phenomenon. In other words, if an option has £2 in time value and 10 days to expiration, it won’t necessarily lose £0.20 in time value every day for 10 days. The option’s theta and its time value can change over time based on factors such as the underlying stock price, market volatility, and more.