What is Theta Decay?

Theta Decay is an essential component of options trading. Check out the short video below to learn more about it and how you can use it to improve your trading!

Understanding Theta Decay in Options Trading

Introduction

What exactly is theta decay? Also called time decay, theta decay refers to the gradual reduction in the value of an options contract over time. What is theta itself? It’s actually a numerical measurement of how much an option’s price is going to decrease for each state that passes, assuming all other factors remain constant.

Factors Affecting Option Pricing

In previous videos, we’ve talked about some of the other factors that influence option pricing, such as intrinsic value, extrinsic value, time to expiration, and volatility. Time itself is going to be a critical factor in the extrinsic value of options. When we look at the extrinsic value of options, we’re talking about what the option is priced at today based on where the underlying asset is.

The Role of Theta Decay

Understanding theta decay can help you as an options trader figure out how time can work for you or against you. Theta decay affects the extrinsic value of options, which is the portion of the option price that is not intrinsic value.

Visualizing Theta Decay

As shown in the video above, the risk profile graph illustrates how the price of an options contract would decay over time. The graph shows that theta decay accelerates as the option approaches expiration, making it an important consideration for option traders.

Example of Theta Decay in Action

Let’s take a closer look at an example to see how theta decay impacts option pricing. Suppose we’re looking at an options contract with a strike price of $376 on SPY with 90 days to expiration. Each day, assuming all else remains constant, the option’s price would decrease by $0.08 due to theta decay. As we move closer to expiration, such as 60 days or 30 days to expiration, the rate of theta decay increases, leading to a faster decline in the option’s price. This demonstrates how theta decay becomes more pronounced as options approach their expiration dates.

Conclusion

In conclusion, theta decay is a crucial concept for options traders to understand. It highlights the impact of time on option pricing and underscores the importance of considering time decay when developing options trading strategies. Understanding how theta decay affects options pricing can help traders make informed decisions and manage risk effectively in the options market.