What is Time Decay (Theta) in Options Trading?
Theta refers to the change in the option price with respect to time. As options have an expiration date, options will decay in price as time goes by. Theta tells us about the rate at which an options price will decay with time. When buying options, it is best practice to exit the trade as quickly as possible to minimize the effect of time decay eating away at your profits. On the other hand, theta works in favor of the option seller as it is in the seller’s best interest for the option to expire worthless. Furthermore, the speed at which the option price decays with respect to time is not linear. Assuming everything else is constant, weekly options decay quicker than monthly options. This is shown in the graph below where the speed of time decay accelerates closer to expiration. Option sellers generally benefit from selling shorter-dated options vs. longer-dated options.
The OptionsPlay platform allows investors to view the Theta of the option and how much it impacts the option’s price:
Selling the AAPL call option has a Theta of 0.492. This means that the value of the call option will reduce by $0.49 per day (per share). Because options represent 100 shares, the value of the contract will reduce by $4.92 (0.492 x 100). For option sellers, the goal is for the option’s value to expire worthless or to buy to close the contract for less than it was opened for. Therefore, Theta works in favor of the option seller.