What Does Positive Theta Mean for Credit Spreads?

In options trading, the price of an option (known as its premium) is sensitive to the passage of time—known as time decay. As the time to expiration nears, the time value of the option decreases, making an option nearing maturity less valuable compared to options with more days to expiration (DTE).

This “time decay” works at different speeds for options of different maturities or strike prices. As a result, credit spreads—where one option is sold at a greater premium and simultaneously another option is purchased at a lower premium—will also experience the effects of time on its price.

Key Takeaways

• A credit spread involves selling a high-premium option while purchasing a low-premium option in the same class or of the same security, resulting in a credit to the trader’s account.
• Options contracts are derivatives that generally experience time decay (i.e., tend to lose value as time passes).
• Theta is the options risk factor that describes its price sensitivity to the passage of time.
• Credit spreads naturally carry a positive theta, meaning they benefit from the passage of time.

What Is Theta?

Theta is the name for the risk metric that measures the rate of change in an option’s value concerning the passage of time. If an option’s theta is, say, 10 cents, then its premium will decline, or experience time decay, of 10 cents per day, holding everything else constant.

Owners of long options positions would thus experience a negative effect from theta as they continue to hold on to their options contracts. Sellers of options (known as “writers“), on the other hand, can benefit from time decay and receive positive theta.

Of course, sellers of options are exposed to several other risk factors that can negate the positive effect of their theta position—for instance, if the price of the underlying moves significantly or if implied volatility rises. However, certain options strategies known as spreads, can capitalize on positive theta while mitigating the extent of some of those other risks.

Theta and Credit Spreads

A credit spread is an options trading strategy that involves simultaneously buying a lower premium option and writing a higher premium option in the same underlying asset with the same expiration date.

Important

Note that the term “credit spread” can also be used in assessing the yield of a bond over a Treasury. Here, we look only at its meaning in terms of options trading.

This kind of trade yields a net credit when opening the position and profits if the spread narrows. Because there is both a long leg and a short leg in the spread, the overall riskiness of the short position is somewhat offset by the long.

Still, since this is a net short position, the overall theta of the strategy is positive. The position thus appreciates in value as the expiration date gets close as long as the underlying asset stays put.

For example, a bearish trader who expects stock prices to decrease could buy call options (long call) at a certain strike price and sell (short call) the same number of call options within the same class and with the same expiration at a lower strike price.

If the price of the underlying does in fact fall, the writer of the spread benefits. But, if the price of the underlying remains where it is and doesn’t move much at all by expiration, the writer still benefits from the positive theta.

Example

For example, say an investor buys one call option on XYZ shares with a strike price of $30 for $1 in premium and simultaneously writes a second call option with a strike price of $25 and collects a premium of $4. The net credit received is $3 ($4 – $1), or $300 since an equity option has a multiplier of 100. The net credit is the maximum profit the investor can receive.

Now, suppose the theta of the overall position is 0.20. This means that the spread earns $20 per day for our investor if all things remain equal. In this case, the investor is betting that the time decay of the position will increase and that the stock price will remain below $25 by expiration.

What Is Theta in Finance?

In finance, theta is the rate at which the value of an option decreases over time. It measures how sensitive an option’s price is to the passage of time. Options have expiry dates and need to be exercised by those dates otherwise they expire worthless. As such, the closer time moves to the expiry date, the more an option’s value decreases.

Shorter-dated options have high thetas, meaning they lose value more quickly, while longer-dated options have shorter thetas, meaning they lose value more slowly. Traders utilize theta to understand the change in an option’s value. Positive thetas indicate an option’s value is likely to decrease over time while negative thetas indicate that the option may gain value over time. Traders can use this information as part of their options trading strategies to ensure profitability.

Is Theta Good or Bad?

Theta is neither good nor bad, it is just an aspect of an option’s value. Theta measures the rate at which an option’s value decreases over time, known as time decay. This is an inherent aspect of options. For options buyers, theta could be considered “bad” because as time moves on, the option loses value—the longer the option is held, the less time there is for it to be valuable.

For options sellers, theta could be considered “good” since the longer time passes, the higher the chances it will expire worthless, or they can buy it back at a lower value.

What Is an Example of a Theta Option?

Say the value of an option is $5, the theta is 5 cents, and the option expires in 30 days. If all else remains the same over the 30 days, the option will lose 5 cents every day. So after one day, the option will be worth $4.95, after day two, the option will be worth $4.90, and so on until expiration. This is a simple example. In actuality, the decay will be slower early on and faster towards expiration. So the option may lose 2 cents the first few days and then 10 cents the last few days, for example.

The Bottom Line

As time passes, the value of an option decreases, which benefits option sellers as they can take advantage of the positive theta. Traders can capitalize on this “time decay” by entering into credit spreads (a combination of long and short positions). Traders can consistently utilize this strategy, especially when markets are stable, to generate profits.