When you become more sophisticated as an options investor, you start needing to understand more complicated options valuation metrics like "the Greeks," a group of options equations named after Greek letters . Today, we'll cover the ever important Greek letter of theta (θ).
[caption align="alignright" caption="Knowing theta is an important aspect of more complicated options strategies"] [/caption]
Before delving into the concept of theta, first we must address the concept of 'the Greeks' in general, as these metrics aren't quite the same as other data used to evaluate equities or derivatives. In fact, the Greeks are based on mathematical models designed to predict the way an option will act in the future. Because the valuation of options changes over time in a fashion that is not entirely consistent with the underlying equity, having a fundamental understanding of how these options are likely to perform going forward is imperative.
This is where theta comes in. Theta, as defined by Investopedia , is the "measure of the rate of decline in the value of an option due to the passage of time."
It's important to understand that the valuation of theta is based on an evaluation of an option at a given moment. Because the underlying equity's valuation will change, theta will almost invariably change as well. What you should take away from theta is that this equation serves as a largely accurate predictive model of options decay going forward.
Ok so we have a theoretical understanding of how theta works; now, how do we use it to our advantage? Glad you asked. Essentially, options traders would like, in general, to sell options with higher thetas and buy options with lower thetas -- or selling and buying options both with high thetas, as long as you are selling a more valuable option and buying a less valuable, such as in a call credit spread.
In particular, in the final two weeks before options expiration, theta increases rapidly as the premium in a given option becomes less and less valuable, giving traders an opportunity to profit. Employing such strategies is embracing the fundamental concept that buying options with high levels of intrinsic value and selling options with high extrinsic value will, over the long run, yield more profitable returns than speculating in options consisting primarily of extrinsic value.