Option Trading: What Is Theta?

Focus: OPTIONS

Since option traders seeking out top returns with minimal risk should familiarize themselves with the Greeks, James Brumley of BigTrends.com discusses Theta-also called time decay-and cites a stock example to illustrate why this Greek is so important.

Option trading need not be complicated. But-at the very least-option traders seeking out top returns with minimal risk should familiarize themselves with the so-called Greeks, which simply describe how an option's price may change with respect to the passage of time and the movement of the underlying stock or index. One of the more important Greeks is Theta, though it's also frequently called time decay.

It's a fitting explanation, theta is time decay or the pace at which an option loses value solely due to the passage of time. If all other factors remain constant, an option will lose value as the expiration date nears because the time-based value-the speculative value-of that call or put erodes as the possible price scenarios-at or before expiry for the index or stock in question-narrow.

An example will clarify the idea.

Take, for instance, General Electric (GE) calls that expire in four months and are currently three points in-the-money. Specifically, that would be a strike price of 25 versus a current stock price of $28.28.