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Theta

Options involve risk and are not suitable for all investors.
Options involve risk and are not suitable for all investors. Certain requirements must be met to trade options. Before engaging in the purchase or sale of options, investors should understand the nature of and extent of their rights and obligations and be aware of the risks involved in investing with options. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options (PDF)" before considering any option transaction. You may also call the Investment Center at 877.653.4732 for a copy. A separate client agreement is needed. Multi-leg option orders are charged one base commission per order, plus a per-contract charge.

What is Theta?

Theta represents, in theory, how much an option's premium may decay each day with all other factors remaining the same.
Select to close help pop-up The amount of the option premium that is attributable to the amount of time remaining until the expiration of the option contract.
Select to close help pop-up An option is near the money when the strike price is relatively close to the market price.
Options lose value over time. The moment that the contract is created, time valueHover to view help pop-upSelect to view help pop-upThe amount of the option premium that is attributable to the amount of time remaining until the expiration of the option contract. begins to deplete. The loss in time value of near-the-moneyHover to view help pop-upSelect to view help pop-upAn option is near the money when the strike price is relatively close to the market price. options accelerates as the expiration date approaches. This is a representation of Theta's behaving in a nonlinear fashion.
For illustrative purposes only.
Higher Theta is an indication that the value of the option will decay more rapidly over time. Theta is typically higher for short-dated options, especially near-the-money, as there is more urgency for the underlying to move in the money before expiration.
Theta is a negative value for long (purchased) positions and a positive value for short (sold) positions – regardless if the contract is a call or a put.

How is Theta used?

Long Options and Theta
A long option holder is negative Theta, which equates to buying time. Since time is always depleting, a long option holder needs to capture the time purchased prior to the option expiring and/or experience a movement in the underlying greater than the amount of Theta purchased. Meaning – holding an option to expiration is only profitable if the underlying moves greater than the Theta purchased. Otherwise, Theta can be captured by closing the option prior to expiration.
For Example, if XYZ is trading at $100.00 and a XYZ $100.00 Call is purchased at $3.00, the premium is primarily time value as executing on the contract is not more favorable than the market. If XYZ remains at $100.00 at expiration, the call will expire worthless. The buyer of the XYZ $100.00 Call will lose all of the premium purchased since time is up. If XYZ was at $105.00 on expiration, the XYZ $100.00 Call will now be worth at least $5.00 as the contract is more favorable than the market (buy at the strike, $100.00 and sell at the market, $105.00). However, the purchaser of the XYZ $100.00 Call will capture $2.00 of profit in this scenario as time value has completely decayed. The loss in this scenario is limited to the premium paid and has unlimited reward potential.
Negative Theta typically means time is not of favor however, the risk is limited to potentially make a higher reward.

For illustrative purposes only.

Buyer Beware:

Since options are decaying in value, time favors the seller. The buyer needs extreme price movement to tip the scales.
Select to close help pop-up Selling a call option contract to establish a new position.
Select to close help pop-up Selling a put option contract to establish a new position.
Short Options and Theta
A short option seller is positive Theta, which equates to selling time. As time depletes, the cheaper the option will become and is working in the seller's favor. The option seller can capture profit if the underlying is neutral or is bearish (short callHover to view help pop-upSelect to view help pop-upSelling a call option contract to establish a new position.) or is bullish (short putHover to view help pop-upSelect to view help pop-upSelling a put option contract to establish a new position.).
For Example, if XYZ is trading at $100.00 and a XYZ $100.00 Call is sold at $3.00, the premium is primarily time value as executing on the contract is not more favorable than the market. If XYZ remains at $100.00 at expiration, the call will expire worthless. The seller of the XYZ $100.00 Call will keep all of the premium sold since time is up. If XYZ was at $105.00 on expiration, the XYZ $100.00 Call will now be worth at least $5.00 as the contract is more favorable than the market (buy at the strike, $100.00 and sell at the market, $105.00). However, the seller of the XYZ $100.00 Call will incur a loss of $2.00 in this scenario as time value has completely decayed. The loss in this scenario has unlimited potential and the reward is limited to the premium sold.
Positive Theta typically means time is of favor however, the reward is limited with increased risk potential.

What are other factors to consider?

Select to close help pop-up A call option is out of the money if the strike price is greater than the market price of the underlying security. A put option is out of the money if the strike price is less than the market price of the underlying security.
Select to close help pop-up A call option is in the money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security.
Decay Rate
Out-of-the-money optionsHover to view help pop-upSelect to view help pop-upA call option is out of the money if the strike price is greater than the market price of the underlying security. A put option is out of the money if the strike price is less than the market price of the underlying security. decay faster than in-the-money optionsHover to view help pop-upSelect to view help pop-upA call option is in the money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security..
This is because the deeper that an option moves in-the-money, the more it begins to move toward a Delta of -1 or +1 and the less meaningful time value is for the value of the option. In other words, In-the-money options will typically have a lower Theta. Out-of-the-money options' premiums are comprised of mostly time value therefore they will decay faster. This higher decay rate will be depicted by a higher Theta value of the option.
Select to close help pop-up A call option is in the money if the strike price is less than the market price of the underlying security. A put option is in-the-money if the strike price is greater than the market price of the underlying security.
Theta Absolute Value
All Theta is not the same. Theta increases with at-the-money optionsHover to view help pop-upSelect to view help pop-upAn option is at the money if the strike price of the option is equal to the market price of the underlying security. and decreases with out-of-the-money and in-the-money options as expiration nears. At-the-money options are more likely to be above or below the strike as they are closer to the price of the underlying. In-the-money options begin pricing in mostly intrinsic value at expiration and deep in-the-money contracts lose their time value. Out-of-the-money options have less time value closer to expiration since they are less likely to be above or below the strike.
Select to close help pop-up The amount by which an option total premium exceeds its intrinsic value.
Select to close help pop-up The market's forecast of a likely movement in the underlying security.
Options involve risk and are not suitable for all investors. Certain requirements must be met to trade options. Before engaging in the purchase or sale of options, investors should understand the nature of and extent of their rights and obligations and be aware of the risks involved in investing with options. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options (PDF)" before considering any option transaction. You may also call the Investment Center at 877.653.4732 for a copy. A separate client agreement is needed. Multi-leg option orders are charged one base commission per order, plus a per-contract charge.
View definitions for investment terms in our Glossary.
The material was provided by a third party not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.
For purposes of all the computations discussed in this article, commissions, fees and margin interest and taxes, have not been included in the examples. These costs obviously will impact the outcome of any stock or option transaction. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. Past performance is not a guarantee of future results.
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