Theta is the Greek that measures how quick the time value disappears. It is defined as the value that the option loses for each day.
If nothing happens with the underlying stock price one thing is certain: options will lose value. The reason for that is that an option is an investment in time: it is the possibility that the stock will appreciate during the time to maturity that makes option valuable. Remember that the value of an option consists of two parts: the real value and the time value. When no time remains further movements in the underlying stock are impossible, and at this point the time value is always zero.
An option with a theta value of 0.15 and a price of 3 units will therefore be worth 2.85 units tomorrow if nothing has happened with the stock price. Since the time only can move in one direction theta is always a positive figure, although it is always presented with a minus sign, just to reinforce that theta always has a negative impact on the option’s value. Even though the time value decreases during the move towards maturity, the speed increases more and more as the expiry day gets closer. With short time left to expiration, less can happen that will impact the value of the option.
The loss of time value is most obvious for pari options, which have the largest time value of all options. Obvious minus or plus options (with delta 0 or 1 or -1 respectively) completely lack time value and have a theta of 0 since nothing is expected to happen to the options during the time to maturity.
Theta is closely related with a stock’s implied volatility. The higher volatility the underlying stock has the higher the options time value is, and consequently, the option’s premium. But a higher premium also causes a higher time value that has to erode before the expiry day. In other words: a high volatility in the stock is always followed by a high option theta. If a lot of volatility is assumed when taking an option, one must also be aware that the option could lose a lot of value for every day that passes. Indeed, each position can be seen as a choice between buying volatility and selling time value – or the other way around.
