Theta Explained: What is it & How to Trade it

hey guys and welcome back to Mike and his whiteboard my name is Mike this is my whiteboard and today we're talking about theta so over the last few days we've talked about Delta we've talked about gamma and how they're related to each other so just a quick recap Delta is the rate of change of an options price and gamma is the rate of change of Delta so those are two tied together pretty tightly there but theta is a little bit different so when we're talking about theta we're talking about the rate of decay of an options price all else equal so what we're going to do today is kind of basically look at two different scenarios so we're going to look at a 45 DTE option or days till expiration option and we're going to compare that to a five day till expiration option and just see what the difference is of those are and also how theta is affected from a buyer's perspective in terms of option prices and a seller's perspective in terms of option prices so let's get into it and look at theta on basically a bell curve level or what you'll see here is more of a linear slope if you will so when we're looking at 45 days to expiration one thing to note is that obviously the most value in extrinsic value is going to be at the money so theta is basically the rate of decay of an options price so if we're looking at extrinsic values specifically we've got the most extrinsic value in the at the money options because again extrinsic value is made up of volatility and time so the most volatility is going to be right at the money because that's the closest in terms of becoming valuable and not being valuable and also when you're looking further out of the money there's going to be less extrinsic value and less probability of being in the money or out of the money so there's going to be that slope as you see here now when we compare this to a five-day ttle expiration value you're going to see that it's a little bit different so if we're just conceptually visualizing this as just a total dollar value you'll see that of course the 45 day till expiration curve is going to be higher and have more value because there's more days till expiration so there's going to be more premium in that so if I'm looking at an option to sell there's going to be more premium it's going to cost me more or I'm going to receive more as a credit if I'm looking to sell a 45 day to expiration option compared to a 5 day to expiration option but what I wanted to display here is simply that the at the money options are going to have the highest data value because that's where the most extrinsic value is regardless of the expiration cycle so let's get into what it looks like for buyers and sellers so if we go to the next slide here we'll take a look at what what an option is so we're looking at buyers and sellers so when we're talking about theta specifically it's good for sellers and it's bad for buyers so let's think about this as a bucket of water so if I've got an option that I bought and the value is a bucket of water and the extrinsic value is made up in time of volatility so if I buy an option contract and I'm basically saying over the next 30 days I think the stock price is going to go up so let's say I buy a call and I think the stock price is going to go up so I buy a call and I'm paying premium for that right to own that theoretical 100 shares of stock for that specific amount of time so that value or that extrinsic value is going to be this water here so if it's bad for buyer because we have theta decay which is the rate of decay of the option price all else equal and when I say all else equal I mean that the price of the stock does not change and implied volatility does not change at all so if you just freeze the entire operation if a date of time passes then whatever your theta value is that's what the option price should decay by so if I'm buying an option and I know that the option price is going to decay or decrease that's going to be bad for me because of the fact that when I buy something I need to sell it to get out of it but the reverse is true for selling options so when I drop this flap here and we start selling options you're going to see that it's basically a two-way street so since a contract is a two-way transaction if there's a buyer and a seller on the contract it theta is bad for the buyer then it's got to be good for the seller so this is one way to visualize it so over time as time passes the option that I bought if I'm buying a call it's going to decay so let's say nothing happened and I bought an out of the money call so I was gambling I wanted to just try out a lottery ticket and see if I was right so I bought an out of the money call if nothing happened or if that stock price did not go high enough for that call to have intrinsic value then basically what's going to happen over time is the option price is going to decay so if that's bad for me as the buyer then that must mean it's great for the seller and that makes perfect sense when you think about it so if I'm buying the call that means someone else had sold the call to me so if they sold it for let's say $1 and over time that that option has decayed to 50 cents or 40 cents because theta has been working for them instead of against me then that's great for them because now they sold it at $1 they can buy it back for 40 cents which the difference is going to be their profit of 60 cents so that's why we always say that theta decay is good for option sellers and bad for option buyers and that's basically the case for any type of trade even if I'm buying a debit spread theta is still going to be working against me so that's why we like to stick to premium selling opportunities so when we have implied volatility spikes which we know is a result of option prices inflating then once that happens I have a large and a large amount of premium that I can sell and theta decay is going to be high relative to what it might have been if the option price was lower given that certain amount of days so hopefully this helps but now let's take a look at what it means when we're looking at a 45 dte graph compared to a 5 dte graph and we're going to talk about some implications of theta when we get closer to expiration so if we go to the next slide here we're going to take a look at the 45 day till expiration graph then we're going to just take this look as a dollar value so again like we were showing before the value for at the money options is going to be highest and it's going to trail off in terms of externs value as you go far out of the money and far in the money now we can when we compare that to a five-day til expiration graph you'll see like when we were talking about with Delta and gamma when I was showing you that the curve goes from very wide to very narrow as you get closer to expiration you can see that clearly here so when we have five days to expiration the most value is still going to be at the money but you can see that since we've already trailed off on the outskirts basically theta decay is going to slow and when we're at the money theta decay is going to increase so let's break this down visually here and you can clearly see this so when we've got beta and we're looking at the money when time passes essentially theta is going to increase so basically one way to think about this is when you're very far out in time like if you're a hundred days out in time theta is going to appear to be pretty linear but when you get closer to expiration theta basically spikes up for at the money options because at the money options are still going to hold their value but now there's only five days left so if I have a dollar but it needs to decay over the next five days I'm going to have a pretty high theta value compared to an option that maybe I sold 50 days out in advance and now it's got a much lower theta decay because now it has 50 days to decay as opposed to five so that's where that relationship comes into play so when we're looking at at the money options specifically you're going to see theta creep up and become much more nonlinear the closer we get to expiration now the opposite is true for out of the money and in the money options and that's simply because of the fact that extrinsic value doesn't really exist anymore so when we're looking at the 45 day till expiration graph you can see at this first strike here we still have a lot of value but if we look at the exact same strike here there's not much value left so if I've got maybe 10 cents of value in that option over the next five days of course it's going to decay still but there's not really much left for it to decay by so the more decay is the slower it's going to decay you should see that number go down as you see here so those are some real key concepts with theta one of the biggest things to note is that it's a nonlinear value so you're going to see theta jump all over the place especially when you're looking at the platform because this is an example when we're holding off else equal so when we're took when we're looking at the option price and stock price not moving at all and implied volatility not moving at all this is maybe what you might see but since we all know that the stock price moves all over the place and so does implied volatility we're going to see a very nonlinear and very dynamic theta value pretty much all the time so let's get to some takeaways here so our first takeaway is that theta is the daily decay of an option price all else equal so again you're going to see this pretty much jump around all the time but if you were to freeze implied volatility and freeze the stock price whatever value you see for theta if you just let one day pass theoretically that option price should decay by that amount and regarding whether you bought or sold that option that's either bad or good for you and theta decay is good for apps and sellers bad for buyers so again if I'm buying an option and I know that I'm paying a premium for that contract right to hold that theoretical shares whether it's long or short shares over a certain amount of time I'm basically paying for that and I know that theta is going to be shown as a negative number for me on the flip side if I'm selling the option theta is going to be a positive number for me because I know that that's a good thing for me so if I sell an option at $1 and it decays by 3 cents every day and that theta number is going to be dynamic of course but if I freeze something if I freeze that stock price and I've got it at $1 and a day passes and I know I have 3 cents of theta the next day I look at it theoretically I should be looking at 97 cents so if I were to close that not including commissions I would see a three dollar profit and another takeaway is that theta changes as extrinsic value and time changes so this is really important to note and especially since there's the most extrinsic value in at the money options you're going to see theta kind of jump all over the place so it's a good snapshot to kind of take a look at and basically when you're when we're creating positions we want to have a high theta value that's really where we kind of want to make all our bread and butter in terms of the specific strategies we're using just because the higher theta value we have if we have a delta-neutral portfolio then that's going to be good for us in terms of just churning the wheels and collecting that premium some additional takeaways is that theta is nonlinear especially closer to expiration so when you go really far out in time theta isn't really an issue because you'll see that the number is very low and it appears to be pretty linear but when you get closer to expiration since it does different things for different options like we discussed how at the money options are the theta is going to increase whereas out of the money and in Lamoni options they is going to decrease it's going to mean different things and it's going to send theta in different directions for different positions and decay increases with at the money options decreases with out of the money and in the money options as expiration nears so this is really important to be aware of so at expiration we know of gamma risk that we talked about yesterday which is the rate of change of Delta and because of that we also have a very high theta change so with at the money options we're looking at an increase in theta whereas out of the money options there's not much value left anyways in terms of extrinsic value so there's not much theta to decay in general which is why you'll see that value dropped down so this has been theta hopefully this has been helpful if you've got any feedback at all shoot it over to our emails here support at doe comm or support at tastytrade comm or you can tweet us at doe trading at tastytrade or at doe trader Mike and tomorrow we're going to start talking more about strategies so we're going to get into strangle and we're going to talk about inverted strangles on Tuesday which is one of our viewers Frank had requested that specifically so we've got that on the docket so it should be a next cool few days so thanks again for joining me this has been Mike in his whiteboard have a great night hey everyone thanks for watching if you liked this video give it a thumbs up or share with a friend click below to watch more videos subscribe to our channel or check out our website

Channel: tastytrade

Views: 96,416

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Keywords: theta options trading, options trading, stock market, options, how to trade options, theta, option greeks explained, stock trading, option greeks, days till expiration, options for beginners, tastytrade

Id: hCtTVaRxTNE

Length: 13min 29sec (809 seconds)

Published: Tue Feb 02 2016