Theta is enemy number one for the option buyer. It is defined as 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.  To the option buyer, the passage of time is similar to the effects of the hot Florida sun's rays on a block of ice. Each hour that passes causes some of the long option's value to "melt away". Not only does the premium "melt away", but it does so at an accelerated rate as expiration approaches.

If we focus on At-The-Money options and don't worry about the affects of interest rates and dividends, there's a quick and dirty way to calculate how fast an option will decay. Options move at the square root of time. This means if a one-month ATM option is trading for $1, then a two-month option would be trading for 1 x sqrt of 2 or 1.41 and a three-month option would be trading for 1 x sqrt of 3 or 1.73 (see below)

If we work back and say the underlying does not move at all and none of the other variables change, the three-month option's time value will lose 32 cents as soon as it drops to two months; it loses another 41 cents in month 2, and in the final month the option would lose the entire dollar. It's pretty obvious from this example that not only do options decay, but they decay at an accelerated rate as expiration approaches. 

If we plot these points graphically you call see the accelerated curvature of the graph.

Note: this large rate of decay is mainly true with ATM options. If the option is way deep in-the-money or way out-of-the-money, the options will decay in a more linear fashion, largely because these options will have a much lower time value.

Now that we've set the stage, the next blog will dig deeper into theta itself and how to use it to factor in your time decay risk in trading.

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.