Theta (θ), better known as time decay, measures the theoretical loss of an option’s extrinsic value as the expiration date of the contract approaches. Theta represents the extrinsic (time) value of an option contract. Theta is typically calculated on a daily basis, assuming all other pricing inputs remain unchanged.
This lesson will focus on the relationship between long option positions and time decay. Theta is ALWAYS negative for investors who are long option positions.
An investor is long the Potash December 125 call
option contract that has a premium of $7.60 and a daily Theta value of
-.08.
One passing day will reduce the premium of the contract to $7.52
(negative for an investor who is long the contract and positive for
an investor who is short the contract)
The same example can be applied to long put positions. The reason ALL long option positions experience time decay is because as expiration approaches, the extrinsic value lessens as it becomes more unlikely that the OTM option contract will expire ITM.
ATM options experience less time decay initially and more as expiration approaches because the have the most extrinsic value.
Theta decay will typically increase when Implied Volatility (IV) is low or expiration is only days away.
Deep ITM options with a Delta of 1.00 will typically not be exposed to negative Theta.
Theta decay is not always the same for puts and calls with the same expiration date and strike price.
The graph above shows an option premium's extrinsic value over time. As the expiration date of an option contract nears, the extrinsic value of an OTM option decreases. This is because it becomes less and less likely the option contract will finish ITM. This factor "eats away" at the extrinsic value. At the close of expiration day, OTM option contracts will have lost all of their extrinsic value and expire worthless.
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