Options theta is one of the main greeks and one of the most important parameters to consider in options trading due to the huge impact it has over the option premium of both the buyer and the seller.

Like other greeks, option theta is an expression derived from the Black-Scholes model of financial options.

In this article, we will take a look at what is theta in options. Also, we will be reviewing how options theta works so we can make use of it in any of our trading strategies.

So, let us get to it!

How time decay works in options?

By nature, options will be losing part of their value when they approach their expiration date. The reason for that is that it will be less and less probable than the underlying makes a strong move when there is not much time left for the option to expire.

To understand and measure how time decay works in options, we need to consider options theta first.

As we have stated, the theta option greek will tell us how much premium the strategy will lose from one day to the following, and every day, this greek will update until expiration.

Time decay, and thus, theta option greek can be either an advantage or a disadvantage, depending on whether we are buyers or sellers.

An example of how options theta works

Let us take Facebook stock option as an example.

In this case, we going to become buyers for an At the Money option contract. Let us suppose that the current underlying price for this stock is $200, and the strike price of our contract is $199.

We are going to buy the option contract when there is still a month to the expiration and the implied volatility is about 30%. Let us now take a look at the value of our basic option trading calculator here.

Options theta explained with the basic calculator

In this case, theta options greek is -0.114 for the call option. If the premium is now worth $7.47, theta option greek is telling us the following information:

If the underlying price was to remain exactly the same for one day, our At the Money call option would be losing 0.114$, thus the premium would be $7.356.

In order to check if this is true, we are going to take a look at the basic calculator one more time.

Options theta explained with the basic calculator

Now, the option premium of our contract is $7.35, which was the exact value that theta option greek predicted would be.

That is how time decay works in options, by diminishing the value of the option premium every single day until expiration.

If you are interested in the basic calculator that we have used in this example, you can download it for free here along with our Options Guide, which is also free!

How does theta option greek exactly affect our trade?

An important fact to bear in mind is option theta greek on weekends. Even though these are not working days, time decay will still be present.

In other words: as buyers our strategy will suffer the effects of three options theta (Friday night, Saturday and Sunday) and if we are not careful, that could be devastating. However, as sellers, this is a very positive thing, because our strategy would benefit from this situation.

As you can see, theta option greek can be a devastating enemy or a powerful ally depending on which side we decide to open our options trading strategy.

Why can we only find negative theta options?

By the very definition of how time decay works in options, we will only find negative theta options as in any case, they will be diminishing the option premium.

Unlike other greeks like option gamma, theta in options will provide information about the extrinsic value of our contract.

What would be considered a high theta option greek value?

The highest value of theta in options can be found in those strike prices whose implied volatilities are extremely high.

For example, following the Facebook example above, if we decided to maintain the same parameters but implied volatility (we will change it to 90%), the option theta would now become -0.35, which is the triple of what we had!

So, what is a good theta in options then?

A good value of options theta depends on the side of the contract we take.

For a buying strategy, the best we can do is to look for a low theta option greek that reduces our risk due to time decay.

However, if we are looking to sell options, the best thing we can do is to sell those strike with high volatility. The reason is that we will be collecting much more premium and we will take advantage of a larger theta and time decay.

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How is theta calculated in options?

We will be able to calculate options theta using an expression given by the Black-Scholes model. First of all, it is necessary to obtain all the parameters of the mathematical model, since we will need them. The expression is the following;

As we mentioned before, we will always find negative theta options since option premium of the contract will be diminishing due to time decay. Note that options theta is different for both call and put options.

Last words about how options theta works

As we have seen, options theta is quite a disturbing factor is we intend to buy options, while it is a wonderful help if we want to sell them.

Time decay will always be present in any option strategy we use, so we should always take into account how theta behaves in our trade.

We have seen the meaning of theta in options, but this is only one of the five major greeks. We should always be aware of theta if we plan to have a trade open for quite some time.