Theta Decay and Time-Based Trades
Theta Decay and Time-Based Trades
Theta measures the daily loss of value in an option due to the passage of time. For option buyers, theta represents a cost; for sellers, it represents income. Understanding theta decay patterns helps traders structure positions that benefit from time rather than fighting against it.
Definition and Key Concepts
What Is Theta?
Theta is the expected change in an option's price for each day that passes, assuming no other changes:
- Expressed as a negative number for long options (value decreases)
- Expressed as a positive number for short options (value decreases in your favor)
Example: A theta of -$0.05 means the option loses $5 per contract per day.
Theta Decay Patterns
Theta decay is not linear—it accelerates as expiration approaches:
| Days to Expiration | Daily Theta (ATM Option) | Decay Pattern |
|---|---|---|
| 90 days | -$0.02 | Slow, gradual |
| 60 days | -$0.03 | Still gradual |
| 30 days | -$0.05 | Accelerating |
| 14 days | -$0.08 | Rapid |
| 7 days | -$0.12 | Very rapid |
| 1 day | -$0.25 | Maximum decay |
Theta and Moneyness
ATM options have the highest theta because they have the most time value to lose:
| Moneyness | Relative Theta |
|---|---|
| Deep ITM | Low (mostly intrinsic value) |
| ITM | Moderate |
| ATM | Highest |
| OTM | Moderate to high |
| Deep OTM | Low (little value to decay) |
How It Works in Practice
Calculating Theta Exposure
Single Option: Daily theta loss = Theta × 100 × Contracts
Example: 5 contracts with theta -$0.08 Daily decay = -$0.08 × 100 × 5 = -$40 per day
Portfolio Theta: Sum theta across all positions:
| Position | Quantity | Theta | Daily Contribution |
|---|---|---|---|
| Long $50 calls | 3 | -$0.06 | -$18 |
| Short $55 calls | 3 | +$0.04 | +$12 |
| Net Theta | -$6 |
This portfolio loses $6 per day to time decay.
Theta-Positive Strategies
Strategies that profit from time decay include:
| Strategy | Net Theta | Risk Profile |
|---|---|---|
| Short put | Positive | Significant downside risk |
| Covered call | Positive | Upside capped, stock risk |
| Iron condor | Positive | Defined risk, range-bound |
| Calendar spread | Positive | Vega and gamma risk |
| Short straddle | Positive | Unlimited risk |
Theta-Negative Strategies
Strategies that pay for time include:
| Strategy | Net Theta | Profit Driver |
|---|---|---|
| Long call/put | Negative | Directional move |
| Long straddle | Negative | Large move either direction |
| Long calendar (back month) | Negative | Volatility expansion |
| Protective put | Negative | Insurance against decline |
Worked Example
Short Put Theta Trade
XYZ trades at $50. You're neutral-to-bullish and want income from theta.
Trade:
- Sell 1 XYZ $48 put, 30 DTE
- Premium: $1.25
- Theta: +$0.04 per day
- Delta: +0.28
Position Metrics:
| Metric | Value |
|---|---|
| Maximum profit | $125 (premium collected) |
| Maximum loss | $4,800 - $125 = $4,675 (if stock goes to $0) |
| Breakeven | $48 - $1.25 = $46.75 |
| Daily theta income | $4 |
| Expected 30-day theta gain | $4 × 30 = $120 (approaches max) |
Theta Decay Schedule:
| Days Remaining | Estimated Put Value | Cumulative Decay |
|---|---|---|
| 30 | $1.25 | $0 |
| 20 | $1.00 | $25 |
| 10 | $0.60 | $65 |
| 5 | $0.30 | $95 |
| 1 | $0.05 | $120 |
| 0 (if OTM) | $0 | $125 |
Iron Condor Theta Trade
SPY at $450. You expect range-bound trading.
Trade:
- Sell $440/$435 put spread
- Sell $460/$465 call spread
- Net credit: $1.50
- Net theta: +$0.06 per day
30-Day Projection:
| Week | Days | Cumulative Theta | % of Max Profit |
|---|---|---|---|
| 1 | 7 | $42 | 28% |
| 2 | 14 | $84 | 56% |
| 3 | 21 | $126 | 84% |
| 4 | 28 | $150 | 100% |
Many traders close iron condors at 50% of max profit (~day 14) to avoid gamma risk in the final weeks.
Risks, Limitations, and Tradeoffs
Theta Alone Doesn't Guarantee Profit
Positive theta doesn't mean guaranteed income. Losses from delta (underlying moves) and vega (volatility changes) can exceed theta gains. A short put earning $4/day in theta can lose $200 instantly if the stock gaps down.
Accelerating Decay Requires Timing
Maximum theta decay occurs in the final week before expiration, but this is also when gamma risk is highest. The "sweet spot" is often 30-45 DTE, where theta is meaningful but gamma is manageable.
Weekend and Holiday Decay
Options don't trade on weekends, but time passes. Some theta decay is priced into Friday closes, but pricing isn't always efficient. Holiday weekends can create similar dynamics.
Theta for Complex Positions
Calendar spreads have positive theta but are also long vega. If IV drops, the vega loss can exceed theta gains. Always consider Greeks together, not in isolation.
Common Pitfalls
-
Assuming theta is linear: Decay accelerates near expiration; don't extrapolate early-period decay.
-
Ignoring delta risk: A theta-positive position can still lose money from directional moves.
-
Selling too close to earnings: High IV means high theta, but also high vega risk from post-earnings crush.
-
Holding winners too long: Theta gains diminish relative to risk as options approach zero; close before maximum gamma.
-
Overleveraging theta strategies: Multiple short premium positions compound risk in volatile markets.
Checklist for Theta-Based Trades
- Calculate net position theta and expected daily income
- Assess delta exposure to understand directional risk
- Check vega to understand volatility exposure
- Choose expirations in the 30-45 DTE sweet spot for balanced theta/gamma
- Set profit targets (often 50% of max) to reduce late-stage risk
- Monitor upcoming events that could move the underlying
- Don't exceed position size limits—theta strategies require consistent execution
- Track actual vs. expected theta gains to refine strategy
Next Steps
Volatility affects option prices through vega, which interacts with theta in complex ways. See Vega Exposure to Implied Volatility Changes for understanding this relationship.
For gamma's impact on theta strategies near expiration, review Gamma and Managing Convexity.