Option Trading: What Is Theta?

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. The option is presently priced at $3.70 or $370 per contract.

With those parameters, theta is a mere -$0.005, meaning the contract loses half a cent per day of its value right up until its expiration date. If nothing else changes in the meantime, the option will be priced at approximately $3.28 on expiration day. Time decay is minimal in this case because the call is relatively deep in-the-money.

Conversely, let's look at other GE call options that aren't as deep in-the-money nor with the same time frame.  A call option with a strike of only a 27 versus the current price of $28.28-and an expiration that's only two months out-would cost $1.85, or $185 per contract, and would sport a theta of -$0.01. That is, it would lose a penny of its value every single day just through the passage of time.  Time decay is accelerated in this case because it's not as deep in-the-money and there's not as much time left before the option expires.

Time decay works the same way for put options... To read the entire article click here.

By James Brumley of BigTrends.com