Many people talk about how time has effected their lives. The aging process is a common complaint with creaky knees and achy backs and bills to pay. Father Time is the “enemy” in this situation. But when it comes to selling options and taking advantage of theta, Father Time can be your best friend.
Theta is another Greek, and is another things that traders live for. Theta is the rate at which the premium of an option decreases over time. This is known as option decay, which increases as we near expiration.
The option price drops by the given theta value each day. So if today we had a call at $2, and a theta valued at .05, the call would be priced at $1.95 the next day.
This is GOOD for option sellers. The decrease in price means that we can buy it back at a lower price. Logically, this means that option buyers do not benefit from theta decay. The decrease in price means that they sell it back for less than they bought it. So when we are selling options, we have positive theta decay, and buying options, negative theta decay.
However, the closer we are to expiration, as mentioned earlier, the “better” it decays. The premium decreases at an accelerated rate closer to when the option is meant to expire. Extrinsic value gets milked out of the option at this point, leaving us trading at intrinsic value.
For example, if we sell 100 ATM (close to stock price) calls for $5 with 45 days to expiration, and the theta is currently worth 0.05 (which equates to a decrease in value of $5 each day) and extrinsic value is $5 (equating to $500 time value), there would be a total decay of $125 ($5 x 45).
Theta is a bit more complicated than beta and delta, but the main thing to take away is that it provides another edge to active investors. Taking advantage of theta decay results in increased profits, especially close to expiration. Theta represents what we can simply make on the passage of time, without holding much additional risk. Sounds like a pretty good deal to me!
Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.