Tuesday, June 8, 2010


Theta is a greek value that represents the decay factor in an option.  All options lose value (extrinsic value) as they move to expiration.  The extrinsic value of ALL options will be 0.00 (zero) at expiration.  

Theta is normally listed as a negative number and is the dollar amount that is lost each day.  If the Theta is listed as 0.10 on a particular option, then that option will lose $0.10 in value per contract share each day.  If the option is priced at $5.65, then tomorrow that option will be worth $5.55.  A long option will be listed as a negative number and a short option position will have a positive theta.  If the trader notices a large negative Theta value, then this will represent a high degree of risk with respect to time decay.

With respect to Long Directional Calls and Puts, Theta can be viewed as a friend instead of an enemy if attention is paid to how much time is purchased up front and when the trader exits the trade on the back-end.  Generally, if the trader if buying Calls or Puts, then they should buy 4-6 months of time and if they are still in their positions at approximately 60 days prior to expiration, then it is suggested that they exit.  The curve of Theta decay becomes a very steep slope at 30 days and so to avoid an emotional decision, it is best to exit at around 60 days prior to expiration.
For the trader that shorts a position, Theta is a friend, not an enemy.  

Next time, we will talk about Gamma.  Remember that a large positive gamma correlates with a large negative theta, and a large negative gamma correlates with a large positive theta.  We'll discuss this and other aspects of Gamma in the next post.