Time value, also called "extrinsic value," is calculated by taking an option's market price and subtracting it’s intrinsic value. Time value diminishes continuously, and eventually reaches zero at expiration. Let’s look at the specifics of time decay.

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What is Theta?

Options are depreciating assets. From the moment of purchase, their value continually diminishes due to time decay. The Greek letter Theta represents incremental measurements of time decay.

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More specifically, Theta represents the approximate decrease in the value of an option as one day passes, with all else equal. For option buyers, the Theta value in their positions is negative, meaning long options lose time value as the expiration date approaches. In contrast, the Theta value of short option positions is positive, allowing option sellers to benefit from the decay in time value.

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For example, you can buy a "16 Dec $160 AAPL call" with 60 days until expiration at the premium of $1.87 per share, or $187 total. The contract has a Theta of -0.0421, meaning it will lose $4.21 (=$0.0421*100) as one day passes, presuming that nothing else– share price, volatility, etc. – changes.

Theta Value Changes as Expiration Approaches

As we know, the longer until expiration, the more time value is left in the option value. The Theta value changes as expiration approaches and behaves differently with different strikes.

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Let's look at the chart below to see how the Theta value moves during the lifetime of ITM/ATM/OTM calls by applying the Options Calculator in the Webull app. Tip: the underlying security $SPY is trading at $357.65.

* The example used is for illustrative purposes only.

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After examining the chart above carefully, we have a clearer idea on how Theta works in the different strikes as the time approaches the expiration date, with all else holding constant.

• The time decay isn't the same for every strike. Because there is more uncertainty in the ATM option about whether it expires worthless or in the money, it has the highest time value compared to OTM/ITM options, with more time premium to lose in the same period. Consequently, the Theta value is higher for ATM options, indicating a higher time decay.

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• The time decay effect is non-linear. In other words, the rate of time decay is not constant. As time approaches, the ATM option loses time value at a higher rate, with the highest Theta value on the expiration date.

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The closer to expiration, the less uncertainty lies in ITM/OTM options, meaning the lower time value left in them. Therefore, the Theta value is smaller when approaching expiration for OTM/ITM options.

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The example above only shows the theoretical change in Theta value, with stock price and implied volatility holding constant. In the real world this is impossible. Changes in both IV and stock price will affect the time value of an option contract, consequently altering the Theta value.

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Why Use Theta in Options Trading?

As stated above, Theta is used to gauge how much value an option loses on a daily basis. Theta can have a negative or a positive value, depending on whether the position in question is long or short. Both buyers and sellers can check the Theta value to manage their options positions.

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Option investors need to balance the tradeoff between time decay and other risk factors. Suppose you are long an ATM call option that expires in the next week. ATM call options can lose the time value at a higher rate than ITM or OTM options, and this effect is heightened by the closeness of the expiration. If the stock price doesn't rise high enough, a gain in intrinsic value can be more than counteracted by the loss of time value. You can still suffer significant losses on your long call position even though you correctly predicted the price movement of the underlying stock.

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A basic understanding of Theta will help you make a more informed decision on option trading strategies. The more you learn, the better you will understand the interplay between the option Greeks.

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Want to Take the Next Step?

Learning from practice is an excellent way to further understand the applications of Theta in options trading. Options Paper Trading supports two basic buying strategies (Long call/Long put) and two basic selling strategies (Covered call/Cash secured put).

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If you want first-hand experience seeing how your strategy can be influenced by Theta, tap here and get started with paper trading!

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Share your paper trading results and experiences with Theta in the comments!

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Disclaimer: All trading symbols displayed are for illustrative purposes only and are not intended to portray recommendations