Options trading may already be part of your investing strategy if you’re a DIY investor. But whether you’ve been doing it for a while or are just getting started, it’s helpful to become proficient in the options concepts and lingo to be as successful as possible. Specifically, it helps to be well versed in the options Greeks.
The Greeks are a way to measure the relative sensitivity of an option’s price to stock prices, market volatility, and timing. Reminiscent of the sororities and fraternities you might remember from your college days, the option Greeks are delta, gamma, vega, and theta.
Theta’s particular role in the Greek-squad focuses on time decay, which just means how much value an option loses over the course of time. If you’re interested in options and specifically, the impact of Theta, keep this primer handy as you’re building out your strategies.
How Theta Works
A key tenet of options trading is knowing when the time window for a particular option position will close, commonly referred to as “time to expiration.” Theta measures the decline in value of an option over time as it reaches expiration. In the options market, the passage of time has been compared to the effect of the hot summer sun on a block of ice. Each moment that passes causes some of the option’s time value to “melt away.” And not only does the time value decrease, but it does so at a more rapid pace the closer you get to expiration.
Generally, Theta is considered to the enemy of the options buyer while a friend to the options seller. That’s because, as time decays, it becomes cheaper for the seller to buy back the options to close out short positions.
Theta is represented in an actual dollar or premium amount and may be calculated on a daily or weekly basis. It’s important to keep in mind that it’s not a hard and fast measure of an option’s value; it’s all theoretical. Theta assumes that price movements and implied volatility are ongoing, so the rate of time decay for an option isn’t necessarily the same from one day to the next.
At-the-Money vs. In-the-Money vs. Out-of-the-Money
At-the-money, in-the-money, and out-of-the-money are three other relevant options terms that are helpful to know. All three tie into time decay and its impact on an option’s value.
When an option is at-the-money, or ATM, it means the option’s strike price–or the price at which the option can be bought and sold–is the same as the price of the underlying security.
In-the-money, or ITM, for an equity call contract means its strike price is less than the current underlying stock price. An equity put contract is in-the-money when its strike price is greater than the current underlying stock price.
An option that’s out-of-the-money, or OTM, for call options means the strike price is higher than the underlying asset’s market price. Again, with put options, it’s the reverse; the strike price is lower than the asset’s market price.
So, what does this all have to do with Theta, and what does it mean for option traders looking to turn a profit?
The Theta value is usually at its highest point when an option is at-the-money, or very near the money. As the underlying security moves further away from the strike price, meaning the option is going into-the-money or out-of-the money, the Theta value gets lower.
If an option is ITM at expiration, investors could profit with call options because the market price is higher than the strike price. It would be the reverse with in-the-money put options.
An investor with OTM options would need to sell before the expiration date to maintain any profit. ATM options also have no intrinsic value but they can potentially shift to ITM with a longer window until expiration.
How Theta Compares to the Other Option Greeks
Theta is just one thing to keep in mind when weighing option positions. Here’s a quick guide to the remaining option Greeks and what they measure:
An option’s delta refers to how sensitive the option’s price is, relative to a $1 change in the underlying security. Delta can be positive or negative, depending on if the option is a put or call.
Gamma is a little different. It measures how sensitive the option’s delta is, relative to a $1 change in the underlying security. Gamma is used to track an option’s price movement to determine whether it’s in or out of the money.
Vega highlights how much an option’s contract price changes, relative to a 1% change in the underlying asset’s implied volatility. Essentially, it’s a way to gauge how much an option’s price could move up or down.
The four option Greeks, Theta options included, work together to help you devise a strategy for buying and selling options for maximum profit.
Is Options Trading Right for You?
Like any other investment strategy, options trading involves risks and they aren’t suited for everyone. So it’s important to fully grasp how options work, including the potential upsides and downsides. Understanding Theta, along with the other Greeks, can help you do that and fine-tune your approach.
If you’re comfortable taking the reins of your portfolio, a self-directed account is one way to explore the possibilities of options. Ally Invest offers self-directed trading for the DIYer with a variety of investments, including options.
Start putting options to work today!