Theta Definition: Ultimate Guide for Learning to Trade Options - Bulls on Wall Street

Theta Definition: Ultimate Guide for Learning to Trade Options

theta More greek terms coming at you! After understanding learning what gamma was in yesterday’s article, today we are going to discuss another critical Greek term in options trading: Theta.

What is Theta?

Theta is essentially time decay of an options contract. When you are trading options, theta is your enemy when you are a buyer, and usually the friend of the seller. It is a crucial concept to understand when choosing which option contract to purchase to bet on a stock’s price movement.  Theta is generally expressed as a negative number, like -0.05 for example. A call option contract worth $5 with -0.05 theta will drop in price $0.05 per day the contract is held. So in 5 days time, the contract will be worth $4.75. As the contract approaches expiration, Theta will increase for an at-the-money option contract, meaning that the contract will lose even more value as each day goes by. 

Example

Let’s say we purchased a call option of stock with a strike price of $115 for $5, and the contract expires next Friday, February 22nd. Let’s say the stock is currently trading at $112.50, and theta is $1. As you can see, the option holder is not in a good position. Let’s say that MSFT trades at $112.50 for the next two days. Their call option is now worth $3 because of the time decay. In this scenario, you are holding an at-the-money contract  The loss may be greater percentage-wise for an out-of-the-money contract because of the smaller time value. The longer the contract owner holds the at-the-money contract, the bigger the move the owner needs in the underlying stock to offset their losses from time decay. The owner needs the stock to move above $115.5 for the contract to be worth $5 again. 

Why It Matters

The lesson here is that you do not want to be holding at-the-money contracts for extended periods of time when the option is closed to expiration. You have to be decisive when the stock is trading at a price that is close to making it at-the-money when your contract is currently in the money. High theta options are for capitalizing on short-term momentum in the market. Longer term options have much lower theta because the expiration is much further away, and they are a better option for holding for a long term hold. You can still consistently rip 50%, 100%, and even more on call and put contracts, but you have to know the right times to buy and sell them before they lose value from decay. 

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If you are interested in learning more about options and learning proven options trading strategies, you should check out my upcoming live 6-day live trading bootcamp. It will teach you everything you need to know about how to trade options successfully.  ]]>

Kunal Desai Administrator