What is Theta in Options Trading and How Does it Work?

Theta—also known as time decay—is the one-day rate of decline of an option's extrinsic or time value. Since options have a finite lifespan, they will eventually expire, and whether the contract is in-the-money (ITM) or out-of-the-money (OTM) at expiration will determine if it has any value. Options are decaying assets since their extrinsic value will erode over time or to $0 when they expire OTM.

For this reason, Theta can work against traders holding long options positions as it will require the underlying to move in greater velocity in their favor to make up for lost extrinsic value. However, it does not mean long options positions cannot become profitable. Conversely, traders that are short options can benefit from the passage of time. Theta can decay the value of their short options positions, allowing them to cover or buy their options positions back at a price below their sale price to yield a profit. However, any adverse price action that works against their position—despite time decay—can also adversely affect investors with short options positions and result in losses.

There are many moving parts to Theta in options trading, but let's apply Theta to a real-world example to make the concept more relatable. Have you ever purchased an extended warranty or insurance? If you currently own an extended warranty or insurance policy, you are experiencing Theta decay even if you do not realize it.

Let's look at an extended smartphone warranty for example and assume that Theta is a static figure; it costs $365 for one year of coverage. Since there are 365 days in a calendar year, a one-year extended warranty will have a $1 of Theta decay each day. That means if 100 days pass, the theoretical value of the extended warranty would be $265. In other words, you would not pay $365 for 265 days of coverage when it could get you a year's worth.

A common misconception traders have about Theta is how it impacts an account each day. For example, if you bought an OTM 100-strike XYZ put for $3 ($300) expiring in 30 days, and it had a 10 θ, it does not mean you will see a $10 debit from your account daily. Conversely, if you are short the same contract, it does not mean you will see a $10 credit to your account each day. Theta assumes the market is frozen and the only thing that’s changing is the passage of time, which does not reflect reality. A call option may be gaining value with a stock increasing in price, but it may be losing a little bit of the increased value due to Theta decay. This is a great example of how the Greeks can offset or be in synergy with each other depending on the situation.

With that said, it’s important to understand which side of the Theta coin you’re on in relation to strategy. If you buy an option you’ll see negative Theta, which means your option can lose value each day that the market does not move in your favor. If you sell an option you’ll see positive Theta, which means this same decay is a good thing for your position that you want to decay in value.

Theta can inform traders if their options positions have any extrinsic value remaining. It is important to note that Theta only affects an option's extrinsic value, and that can help traders who are short ITM options if they may be subject to assignment risk. A trader with a short options position with little to no Theta or extrinsic value could face heightened assignment risk, as it may be worthwhile for the counterparty to convert the options position to stock rather than hold the options position. Options with little to no Theta result from the option having little to no extrinsic value, which applies to deep ITM options—regardless of how many days to expiration remain.

Investors long or short an OTM options position can also refer to Theta to see if there is any remaining extrinsic value. Since OTM options only have extrinsic value and Theta affects an option's extrinsic value, it can inform traders that are either long or short an options position how much value—if any—remains on their position. Traders with a long or short options position can use Theta to see how much premium is embedded in the options contract and how it can affect options strategies if everything else stays constant.

Since options and their Greeks quote with a long bias, Theta will display as a negative number because time works against an option's extrinsic value. Moreover, the tastytrade platform expresses Theta on the options chain in Table Mode as a total dollar amount by considering the options multiplier of 100 shares per contract, so you know your total Theta impact. However, Theta's impact differs whether a trader holds a long or short options position.

There are two camps for Theta's impact on a trader's portfolio, depending on whether they are long or buying options positions versus being short or selling options. Traders holding any long options position established for a net debit will have Theta work against their portfolio as it will require the underlying to move in greater velocity in their favor to make up for lost extrinsic value. However, it does not mean long options positions cannot become profitable prior to, or at expiration.

Conversely, traders establishing short options positions for a net credit can benefit from the passage of time. Theta can decay the value of their short options positions, allowing them to cover or buy the options positions back at a price below their sale price to yield a profit. However, despite time decay, any adverse price action that works against their position can also adversely affect investors with short options positions.

• Long Options: Negative θ
• Short Option: Positive θ

To sum up, Theta can work against long options positions but favor short options if the market doesn’t move much over time. However, it is important to note that although Theta may work for or against a trader's options positions, other market conditions can turn a profitable options trade into an unprofitable trade and vice-versa based on various market events like an economic or binary event like earnings. That is why it is essential to consider your overall exposure by referring to other Greeks, too.

One of the most critical but not-so-obvious things that Theta exposes to traders is the amount of risk they have in their portfolio. For example, let's say XYZ is trading at $120/share, and you sell a 100-strike put and collect a $2 ($200) credit that expires in 20 days. When you sold the put, it had a 10 θ, equating to $10/day of Theta decay, assuming all things held equal. As a result, the portfolio would collect $10 in Theta in exchange for taking on $10,000 of notional stock risk (100 XYZ x 100 shares).

However, let's say instead of selling one XYZ 100-strike put, you decide to sell 10. Aside from requiring more buying power to establish the trade, the portfolio would collect $100 of Theta decay each day (10 contracts x 10 θ). In exchange for the higher daily decay rate, you are now taking on $100,000 of notional stock risk instead.

In both cases, if the option expires OTM and is worthless, then the trader stands to make a maximum profit in exchange for taking on the risk. On the other hand, if XYZ dropped to $0 at expiration, then the trader would be on the hook to buy 100 shares of XYZ @ $100 per contract. This is illustrated in the max loss metric displayed in the Trade Info bar during order entry.

In short, there is a direct correlation between the amount of Theta and a trader's risk in their portfolio. So, although time decay is widely associated with Theta, it can also shed light on the amount of risk a trader has on their portfolio.