There are a lot of “rules” that option traders will use to determine what they are buying or selling and when. For example, it is not uncommon for option traders to sell a call when they are bearish and there are only a few weeks before expiration rather than buying a put. These are both short term bearish positions so why is there a bias towards the short position rather than the long put?
[VIDEO] Using Option Greeks: Theta, Part 1
The easy answer to the question above is that because options will lose time value at an accelerating rate the closer they get to expiration it makes sense to sell or short them rather than buy them to capitalize on that quick loss of value. Time value is that portion of an option’s price above its intrinsic value. In the video above I will go into more detail about what that means and how to determine what time value is for any given option. Time value falls until it equals zero at expiration and the decline can hurt your profitability if you are long when the decline starts to accelerate. Therefore short term put buyers are at a disadvantage to call sellers as their puts start “bleeding theta” or time value.
How sensitive an option is to the passage of time is called “theta,” which for option traders is a synonym for time value itself. Theta will tell you how much time value or theta is going to melt each day you hold the option and unlike delta doesn’t change very much on any given day with different strike prices.
In the video below we will work through a case study on an ETF to understand how theta varies based on strike price and expiration date. You will find that the differences in theta from one strike price to the next is fairly nominal. However, theta will typically increase the closer you get to expiration.
[VIDEO] Using Option Greeks: Theta, Part 2
An awareness of theta or time value really applies when deciding whether to short an option where theta can help you and when to go long an option where theta may hurt your returns. In the short term, shorting an option and using theta to increase returns could be ideal. However when evaluating a long term option position or anticipating a very large move in the underlying, price movement is more likely to offset the disadvantages of the decline in time value or theta in a long option position.
Image courtesy Phault.