Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ====== Theta ====== Theta (one of the famous [[Greeks]] of options trading) is the secret sauce that measures the impact of time on an [[option]]'s price. Think of it as a ticking clock counting down the value of your option contract. It represents the rate at which an option loses its value as its expiration date draws nearer, assuming all other market factors remain unchanged. This erosion of value is often called "time decay." For an option buyer, theta is the relentless headwind they face; every day that passes, a little bit of the option's extrinsic value, or [[premium]], melts away like an ice cube on a hot day. For an option seller, however, theta is a tailwind, a source of potential profit as they collect the premium that buyers pay for time. Understanding theta is crucial because, unlike stock price movements or volatility, the passage of time is the one constant you can always count on in the market. ===== How Does Theta Work? ===== At its core, theta quantifies the daily cost of holding an option. It is typically expressed as a negative number. For example, if a call option has a theta of -0.05, it means that, in theory, its price will decrease by 5 cents every day, provided the underlying stock price and [[implied volatility]] don't change. Time is a finite resource for an option, which has a set expiration date. This "time value" is the extra amount investors are willing to pay for the possibility that the option will become more profitable before it expires. Theta simply measures how quickly this time value evaporates. For the two sides of an options trade: * **The Buyer (Long Position):** You have a //negative// theta. Time is your enemy. The clock is always ticking, and your option is constantly losing a small piece of its value due to time decay. For your trade to be profitable, the underlying stock must move in your favor fast enough and far enough to overcome theta's daily toll. * **The Seller (Short Position):** You have a //positive// theta. Time is your friend. You collect the premium upfront, and each day that passes, theta works in your favor, making the option you sold a little bit cheaper to buy back (or more likely to expire worthless), letting you keep the premium. ===== The Speed of Time Decay ===== Time decay isn't a slow, steady drip; it's more like a snowball rolling down a hill, picking up speed as it nears the bottom. The rate of decay (theta) accelerates dramatically as the option gets closer to its expiration date. This effect is most pronounced in the last 30-60 days of an option's life. The "moneyness" of an option also plays a huge role: ==== At-the-Money Options ==== Options where the stock price is very close to the [[strike price]] (known as [[at-the-money]] options) have the highest theta. They have the most uncertainty and therefore the most time value packed into their price. As a result, they have the most value to lose from the passage of time and decay the fastest, especially in that final month. ==== In-the-Money and Out-of-the-Money Options ==== Deep [[in-the-money]] options (those with a strike price well below the current stock price for a call, or well above for a put) behave more like the stock itself. They have a lot of intrinsic value and not much time value, so their theta is lower. Similarly, far [[out-of-the-money]] options have a low probability of ever becoming profitable. The market knows this, so their time value is already very low, and thus their theta is also low. There's not much value left to decay. ===== Practical Insights for Value Investors ===== While buying options is often seen as speculative, understanding theta can unlock strategies that align perfectly with value investing principles. The key is to be the seller, not the buyer. ==== Being the "House" by Selling Options ==== A core tenet of value investing is seeking a [[margin of safety]]. Selling options, when done prudently, can be a fantastic way to generate income and create that margin. Think of it as acting like an insurance company: you sell a policy (the option) and collect a premium. Theta is the mechanism that ensures the value of that policy declines over time, allowing you to profit. * **[[Covered Call]]:** You own 100 shares of a stock you believe is fairly valued and sell a call option against it. You collect the premium, and theta erodes the option's value daily. If the stock price doesn't rise above the strike price, the option expires worthless, and you keep the full premium, boosting your overall return. * **[[Cash-Secured Put]]:** You identify a great company you'd love to own at a lower price. You sell a put option at that desired price, collecting a premium. Theta works for you. If the stock stays above the strike, you keep the premium. If it falls below, you are obligated to buy the stock at your target price, but your net cost is reduced by the premium you received—a built-in margin of safety. ==== The Perils of Buying Options ==== For a value investor, buying options is a tricky proposition. Theta is a constant, unforgiving tax on your position. To succeed, you need to be right about the direction, magnitude, //and// timing of a stock's move. This is a difficult trifecta. If you do venture into buying options, consider long-term contracts like [[LEAPS]] (Long-Term Equity Anticipation Securities), which have expiration dates more than a year away. Their theta is much lower, giving your investment thesis more time to play out without being eaten alive by rapid time decay.