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.
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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