In my previous post on theta, we explained how time premium is calculated and graphed the rate at which an At-The-Money (ATM) option typically decays. Now let's dissect the actual Theta number.

To begin with a straight definition, theta is the amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract. Keep in mind that Theta measures time decay only; it does not account for stock price movement or the myriad of other variables affecting options pricing.

The last post discussed how time decay accelerates as an option nears expiration; accordingly, then, theta is a larger number for near-term options than it is for longer-term options. For example, consider XYZ trading at 100 and the 100 call, trading at 1.15, with an implied volatility of 20% and 7 days remaining to expiration. The one-day theta for this option would be -.085 or a negative 8 1/2 cents. This means if nothing else in the marketplace changes except one day of time passing, this contact will trade for around 1.15 - .085 or $1.065 in absolute terms.

Now let's consider the same option contact, but with 180 days remaining to expiration. The call option would be worth $7 and the theta would be -.025 or negative 2 ½ cents - a much slower rate of decay than the 7-day option.

Regards,
Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

While Theta represents the consensus of the marketplace as to the amount a theoretical option's price will change for a corresponding one-unit (day) change in the days to expiration of the option contract there is no guarantee that this forecast will be correct.