Option Theta measures how much an option's price decreases as time passes, assuming all other factors remain constant.
In financial markets, Theta is crucial for options traders and portfolio managers who include options strategies in their investment approach. It helps in assessing the impact of holding an option over time. For example, a Theta of -0.05 means the option's price theoretically drops by 5 cents daily due to time decay alone, all else being equal. Understanding Theta allows investors to time their entry and exit in options trades and to manage positions effectively by anticipating losses from time decay, especially in cases where the underlying asset is stagnant.
From a tax and reporting perspective, understanding the effects of Theta helps in accurately forecasting potential gains or losses from options and aligning them within financial plans and portfolio objectives. Recognizing the implications of Theta also supports governance over derivative holdings by clarifying how option positions can change in value due to time, enabling better oversight and decision-making in family office investment committees.
Consider a call option on a stock that currently has a Theta of -0.03. This means the option's premium will decrease by approximately $0.03 every day, assuming the underlying stock price and volatility remain unchanged. If the option's current price is $2.00 and the holder keeps it for 10 days without any favorable price movement, the option’s value would decay by about $0.30 (10 days x $0.03 per day), reducing the price to roughly $1.70.
Option Vega
While Option Theta measures price changes due to time decay, Option Vega measures sensitivity to volatility changes in the underlying asset, which also significantly affect option prices.
What does a negative Theta value mean?
A negative Theta value indicates that the option's price decreases as time passes, reflecting time decay. This loss in price occurs daily and is expected in most options because the time until expiration is decreasing.
Does Theta affect all options equally?
No, Theta impact varies depending on factors like time to expiration, the option's moneyness, and volatility. Near-the-money options and those close to expiration generally have higher Theta, meaning faster time decay.
Can Theta be positive for an option?
Typically, Theta is negative because options lose time value over time. However, certain complex positions or deep in-the-money options under specific conditions might exhibit very small positive Theta, but this is uncommon.
