For the next few week’s the Options Theory blog will provide a thorough investigation of Theta. Like savvy sleuths, we’ll follow every lead, tug on every thread. By the time we’re finished you’ll know all his secrets and personality quirks.

If you’re a grizzled vet, this will provide a friendly reminder of what you love and hate about Theta’s behavior. If you’re a rookie, then prepare for a feast of enlightenment.

And hold your head still, so nothing spills out.

What are the Greeks?

Before diving into Theta, let’s place it in the proper context. It is a member of an eclectic group of variables known as the Greeks. Their function is simple, but their application can be complex. Allow me to list out my four favorite ways to describe them:

They measure risk.

They help you determine how much money is on the line.

They answer the question, “how much?” As in: How will I make or lose if X, Y, or Z happens?

They reveal the characteristics of an options contract and thus describe how it behaves.

Pretend you’re a babysitter coming to my home for the first time. You haven’t met my kids before, but you have suspicions that they’re intelligent, precocious, and cute as a button (they are my kids, after all).

To help you handle them, I will provide a list of the important things you need to know about each one, like so:

Sawyer: the ringleader, a sugar thief, hater of teeth brushing.

Harrison: the loyalist, a helper intent on pleasing, lover of books.

Maxwell: the clown, a bringer of joy, survives on yogurt.

Savannah: the baby, sleep-change-feed-play-repeat.

A more expanded note would detail additional behavioral quirks, eating habits, hints on handling tantrums and doling out rewards, etc.

With list in hand, you would be prepared for a successful sitting.

I’ve essentially shared with you the Greeks for my children. You are now empowered to make informed decisions and understand why they’re behaving the way they do.

There are many Greeks in the options market, but the most commonly used (and most useful) are delta, gamma, theta, and vega. Here is what they track:

Delta measures Direction

Gamma measures Growth

Theta measures Time

Vega measures Volatility

Time Decay

An options contract is an interesting character. It bursts from the womb with endless potential, but if you look closely, there’s a date stamped on its forehead. Unlike humans, derivatives know their death date at birth.

Pro tip: We’re using “derivatives” as a synonym for “options contract,” because, well an options contract is a derivative and my English teacher told me using the same word over and over is lazy writing.

And, like humans, the passing of time has an impact. While options don’t lose hair, teeth, or memory as Father Time works his magic, they do lose value. The price of an option is known as its premium. Part of the premium comes from something called intrinsic value. The other part is known as extrinsic value. And since extrinsic value is the part of the option’s value that is impacted by time, many call it time value. This is the portion of the premium that is sensitive to the passing of time.

Since options decay over time, we call it time decay. Study the following graphic:

The vertical axis represents the amount of time value in an option. The horizontal axis represents the months remaining until expiration. You’ll notice the rate of decay accelerates into expiration. That means a one-month option will lose more money per day than a one-year option. The higher rate of time decay near expiration is why so many strategies involve selling short-term options. The aim is to capitalize on their higher sensitivity to the ticking of the clock.

Enter Theta

This is where Theta enters the equation. It measures how much an option loses in value per day. If you buy a call option and your theta is -5, then you theoretically lose $5 per day. If the theta is -1, then you’re losing $1 per day.

But theta isn’t always negative. If you sell options, it turns into a positive number. Strategies like covered calls, naked puts, credit spreads, and condors all boast positive theta. That means they profit as time passes. The world of cash flow trading involves selling options with the intent of profiting from Father Time.

We will explore this idea and many other facets of Theta in subsequent parts of the series. Stay tuned.

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