Understanding Theta: Definition and Why It Matters

Options are contracts that give you the right to buy or sell a stock at a set rate by a certain date without any obligation. Like many other underlying assets, options come with a risk. That’s why before you choose an option contract, you need to assess this risk by looking at the Greeks – delta, gamma, vega, and theta. Let’s take a deeper look at theta.

What Is Theta?

The definition of theta is that it measures the value of an option in regards to how much time is left before the set expiration date. In other words, it’s an option’s time decay, since it may lose value as you get closer to the maturity date. It also tells you how much the underlying asset will need to change in order to offset the loss in value as indicated by theta.

Typically, theta is a negative number, and it represents how much you can anticipate an option’s value to decline each day. If all the other variables of your option contract are constant until it expires, you can expect it to lose value as you get closer to the expiration date.

An Example of Theta

Let’s say that you purchase a call option, which means that you have the right to buy stock. If theta is $1, then you can expect the value of the option to drop $1 each day until it expires. This should matter to you because you are losing every day you get closer to the expiration date.

Other Main Greeks

The other Greeks also measure your option’s risks. They are named after Greek letters and help you measure the sensitivity of your option. Here are the main Greeks other than theta that you should look at:

• Delta: Measurement of the impact of an underlying asset’s change of price. Its value ranges from 0 to 100 for calls and 0 to -100 for puts.
• Gamma: Measurement of delta’s rate of change. Gamma can help you predict how much you will gain or lose based on how the underlying position moves.
• Vega: Measurement of the impact of a change in volatility. While it looks at future volatility, delta focuses on the actual price changes.

Choosing Options Based on Time Frame

Options are contracts that give you the option to buy or sell an underlying asset at the strike price before it reaches its expiration date. Theta can help you choose between two similar options with different expiration dates. You may want to pick the long-term option because it could have more value since it has more time to move beyond the strike price. When you want to sell an option, this is known as a “positive theta trade.” When the theta accelerates, you can get increased earnings on your options.

Options trading is a tedious process, but if you pay attention to sensitivity measurements like theta, you can learn a lot about your options. By studying each of the Greeks, you can have a better idea of where your option contract is heading.

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