The simplest way to describe theta in options trading is that it is the daily decay of the extrinsic value of an an option.
Therefore, theta is a useful concept only when combined with other indicators and set within the greater context of an option’s price and projected price movement.
Trading with Theta
Theta is positive when we are selling an option. Any option with time left before its expiration will have value, and the decay of that value based on the option’s Theta is positive for the seller of an option.
If you sell a put for one dollar, you will eventually need to close the position by repurchasing that put.
To close at a profit, the put will need to be worth less than one dollar when you buy it back.
Theta works in favor for the sellers of options because the daily decay in the price of an option means that value will erode the premium even if the underlying isn’t moving. That’s why sellers have a huge advantage over buyers.
Negative Theta, on the other hand, occurs for the buyers of options.
The value of options held will decay each day as the end of the contract draws nearer. Therefore, to realize a profit, we require that the price or volatility of the underlying security change in our favor. The required change grows larger as each day passes and Theta eats away at the value of our option.
This is why many buyers of options will hedge their long option positions to counteract the effect of Theta that is an inherent part of options trading.
Warrior Trading Pro Tip
It is critical to remember that it is a metric that assumes the price and volatility of the underlying security are stable.
However, in reality markets are constantly in motion, so this stability will never actually exist in the real world of trading. It is unrealistic to expect the value of an option to change by its Theta each day.
While the value of Theta will effect the price of the option, it will also depend on the changes in price and volatility of the underlying security.
That said, as a trader you can be sure that Theta will constantly and consistently be eating away at the value of any option, which is a plus for sellers and a drawback for buyers.